The Metamorphosis of Emerging Markets
The relative performance of emerging markets has been unremarkable over the past decade, however meaningful changes have taken place in the fundamental and financial construct of the asset class that are relevant for asset allocators. Most notably, the composition of the index has seen dramatic shifts in sector, country, and stock constituents, reflecting an underappreciated transition in the fundamental forces increasingly driving developing market economies. Rising consumerism and growing everyday use of technology within the developing world represent meaningful fundamental changes in economic behavior and such thematics are accessible through a growing number of listed corporates and globally competitive companies.
Additionally, prudent macroeconomic policy implementation and selective structural reforms have laid the foundation for more stable and sustainable long-term economic growth, while companies are being managed in a more efficient and shareholder-friendly manner. With longer-term valuation metrics remaining attractive for many developing equities on a comparative basis, the significant changes to the emerging markets asset class are increasingly important to consider. Because we feel that some of these shifts in the emerging markets story may be underappreciated or misunderstood, in this piece we present views from various team members pertaining to the changing face of emerging markets.
The Opportunity Set is Improving
Over much of the past thirty years, the emerging markets asset class has frequently been regarded as something to “rent” as opposed to own for most investors. Known for commodity-reliant economies and cheap sources of manufacturing labor, developing nations’ financial markets historically gyrated around the ebbs and flows of global economic activity. While this phenomenon has not entirely vanished, the composition and macro sensitivity of emerging market equities have nonetheless been shifting. Part of this transition can be explained by the fading omnipotence of globalized trade as well as a somewhat related policy-driven emphasis on spawning more domestically-oriented economies. Developing countries’ demographics position them well to pivot in this direction and unsurprisingly, the evolution of the asset class has reflected this reality (Figure 1), with consumer-related equities now composing a greater percentage of the MSCI Emerging Markets Index than cyclicals.
While the steady ascent in developing market consumerism has been materializing for nearly a decade, the more recent quantum leap in technological innovation and adoption in emerging markets has been surprisingly abrupt. China illustrates a prime example of this development, with industries such as shopping centers completely marginalized by e-commerce behemoths Alibaba, Tencent and JD.com. These platforms are revolutionizing consumer, merchant, and advertiser behavior through digital ecosystems and are increasingly proving to be globally competitive (yes, even against the likes of Google and Facebook) in areas such as artificial intelligence, e-payments, and logistics. China has similar long-term aspirations in other areas including healthcare.
Alongside the changing fundamental landscape of the developing world, the financial framework is evolving as well. Brazil, for example, has introduced the Novo Mercado market index that sets out more stringent listing rules defined as:
“Good corporate governance practices, more stringent than those present in the Brazilian legislation. These rules, consolidated in the Listing Rules of the Novo Mercado, expand shareholder rights, improve the quality of information usually provided by companies and widespread ownership, and determine the resolution of corporate conflicts by a Board of Arbitration that offer investors the security of an alternative more responsive and specialized.” (Source: BM&F Bovespa)
In another example, China has recently enacted steps to increase access between mainland China (known as A-Shares) and Hong Kong (which provides a platform for global investment money) financial markets. The program, known as “Stock Connect” aims to improve mutual market access as part of a strategic plan targeted at deepening and broadening the accessibility of Chinese equities, and ultimately bonds as well. The launch of the connect program involved various operational and legal issues including T+0 trade settlement, payment, delivery, and the creation of trade accounting structures. Thus far, the connect program has proven successful and represents an incremental step toward greater integration into the global financial system for China.