April 26, 2022

The Future of Emerging Markets Amid a War and a Pandemic

Managers on the ground are more important than ever.

Reported by Anna Gordon

Emerging markets have taken a hit this past year. The iShares MSCI Emerging Markets ETF has fallen to $42.38 a share as of April 18, 2022, from its peak of $57.80 a share during the week of February 8, 2021—a 26.7% drop. Unprecedented lockdowns in China combined with a war in Eastern Europe have caused food and energy shortages and accelerated the diversification of supply chains.

Nevertheless, the inefficiencies in liquidity and information that are often present in emerging markets make many of them places of tremendous potential for investors. But it all depends on having the right management with knowledge of both the specific country and asset class.

The Winners of the War in Eastern Europe

War between Russia and Ukraine has shaken up supply chains for many emerging markets. Russia, known for its role as a major energy exporter, is also among the top producers of wheat, fertilizer, and many metals—including nickel, a major component of most batteries. Ukraine was also a significant producer of wheat and metals and exported electrical machinery and computers as well. While the disruption of these supply chains will undoubtedly harm the global economy, there are some emerging market countries that may be able to take advantage of this situation.

“Within emerging markets, there have been some diversification benefits, because not everything is collapsing,” says Philip Saunders, co-head of multi-asset growth at Ninety One, a global asset management company based in South Africa managing $140 million in EM equities. “Certain resources are going to have to be bought that Russia previously supplied and are going to have to be supplied by other countries.”

Saunders named Qatar as one of the major beneficiaries in terms of natural gas production. He was also optimistic about South Africa.

“For all its structural challenges, South Africa is a resource producer in a general sense, and a significant producer of agricultural products,” says Saunders. Another potential predictor of emerging market success is demographic data on the particular country, according to Jean-Christophe Lermusiaux, senior portfolio manager at British Columbia Investment Management Corporation. He helps run BCI’s in-house active emerging markets investment team.

“The market very often forgets the impact that education levels and the inclusion of women in the workforce can have on the long-term growth outlook for a country,” says Lermusiaux.

Lermusiaux says countries like India, Egypt, Nigeria, and South Africa all have promising demographic trends that point to potential for growth in the long run. On the other hand, he named China, Hungary, and the Czech Republic as countries that have more worrying demographic trends.

“Growth is about demography, productivity gain, and investment,” says Lermusiaux.

The Future of China

As Chinese growth grates have begun to decline over the last decade, investors have become increasingly cautious, according to redemption data from EPFR Global. While investors had been bullish during the early part of the first quarter, the second week of March saw investor redemption rates increase dramatically.

“Redemptions from China equity funds hit their highest level since the first week of 2021 and outflows from China bond funds exceeded $1 billion for the first time ever,” states the report.

The massive COVID-19 outbreak in Shanghai combined with the Chinese Communist Party’s unwavering zero-COVID stance appears to have dampened investors’ hopes as many aspects of production inside the country have ground to a halt. This has also forced China to loosen its monetary policy, leading to its currency being devalued.

“China has been a relative loser, at least in the short term,” says Saunders. But one country’s misfortune could be another’s opportunity: China, which still dominates global manufacturing industries, could see significant competition.

“I think that Vietnam and Bangladesh are probably in good position to benefit from the kind of stuff that that was sourced in China, certainly at the lower end,” says Saunders.

The two countries are known for their apparel and manufacturing exports, which were traditionally a powerhouse for China. But despite China’s current challenges, Saunders thinks investors should be careful not to underestimate the country.

“A lot of asset allocators are saying, you know, we’ve had enough of this underperformance. It’s the final straw. China is uninvestable. We’re out,” says Saunders.

According to Saunders, that’s probably a mistake.

“China, from a cyclical perspective, is somewhat challenged. But ultimately the major structural drivers of China’s growth are still very much in place,” Saunders says.

Choosing the Right EM Managers—People on the Ground are Key

When it comes to emerging markets, investors agree that active management is critical.

“Having active managers right now is incredibly important and protects the institutional investor from a lot of turmoil in the markets,” says Kevin Edwards, senior investment director at Hartford Healthcare.

Edwards says that one of the things Hartford Healthcare looks for when working with managers to invest in EM countries is whether the manager has people on the ground in that country.

“It absolutely is important for a manager to have people in that particular region in that particular market, who have that specialized knowledge and those specialized networks,” says Edwards. “If you’re only investing in highly liquid, large cap stocks, maybe you don’t have to be as specialized. But if you’re doing anything that is real estate or commodities-driven, specialty is important.”

Edwards says that the managers who have been successful were those that had the flexibility to actively react to trends in emerging markets.

“Our managers have been able to make assessments of the winners and losers based on the current environment and have shifted portfolios accordingly, because they’re not tied to a specific benchmark,” says Edwards.

Edwards says that at Hartford, the priority is to find managers who have proven their ability to produce strong returns, understand how to protect when they need to, and take their fiduciary duty seriously.

“It sounds simple, but it’s so rare,” says Edwards.

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