Emerging markets (EMs) are largely unfamiliar territory for U.S. investors ― and if portfolio allocations are any indication, many of them are keeping their distance.
EM equities come with more risk than their developed counterparts, but over time they also can be a source of growth and diversification in a portfolio. And while more than two dozen countries are classified as emerging markets, no two are exactly alike.
On the latest episode of The Bid, host Mary-Catherine Lader spoke with Gordon Fraser, EM portfolio manager within BlackRock’s Fundamental Active Equity group, about the outlook for EM stocks and why now may be a good time to take a closer look.
Mary-Catherine Lader: What makes a market “emerging”?
Gordon Fraser: Many people think rich countries are developed and the poorer countries are all emerging. That’s a bit of a misconception. In emerging markets, you have some very rich countries like Qatar or the UAE together with quite poor countries such as India or Pakistan. It’s also not about technological development. South Korea, for example, is extremely developed from a technological standpoint. What really defines an emerging market is how developed the stock market is. It’s about index classification and how well a market functions.
China, India and Brazil are some of the well-known EMs. Colombia and Peru are examples of smaller ones. The least established markets are called frontier markets. These are very illiquid. Some countries in Africa would fall into that bucket, like Nigeria or Kenya, or even Vietnam in Asia.
Mary-Catherine: How is investing in emerging markets different from investing in developed markets?
Gordon: First, there are a lot of countries. There are 23 countries in the EM index. They all have their own currency, unlike in Europe, where a lot of countries have the euro. You have big commodity exporters like Brazil or Russia, and big commodity importers like Turkey. All of these countries have their own economic cycle. It’s a varied set in emerging markets. Because of this, you can add a lot of value in emerging markets through choosing which country you’re going to invest in. There is also much more stock-level dispersion. More country dispersion, more stock dispersion ― all of that is great for an active investor.
Mary-Catherine: Emerging markets haven’t performed that well in the past few years. Why is that?
Gordon: The last decade has been pretty tough for emerging markets. I would identify two key headwinds. The first one was the strong U.S. economy. The Federal Reserve was hiking interest rates because the U.S. was doing so well. That was leading to a lot of pressure in emerging markets, which are big borrowers of dollar loans. When U.S. rates go up, that’s like an increase in your cost of borrowing. The other big issue was trade. Emerging markets still have a very export-led growth model. The pressure from the trade war between the U.S. and China was hurting demand in other EM. It was causing corporates to maintain very low levels of inventory and hold back on their capital expenditure plans. This was depressing demand and causing an issue for EM earnings. Both of these headwinds are potentially starting to fade.
Mary-Catherine: Why consider EMs now?
Gordon: We see the cyclical headwinds I just mentioned turning around. That’s one reason. But there’s an interesting structural story as well. If you think about an economy that produces a certain amount of output, you’ve got two ways of producing that output: labor and capital. In the developed world, the share of the economic output that is accruing to capital and the shareholders of those companies is at a 20-year high. In emerging markets, it’s never been lower. So in buying EM, you’re potentially buying into assets where the profitability is below its long-term potential. If you combine that long-term structural argument for buying EM company earnings, let’s say, “cheap,” together with some of the cyclical tailwinds, that makes it an interesting time to be thinking about emerging market allocations quite seriously.