While investors brace for a downturn, emerging markets prepare for the future

Market volatility due to inflation, monetary tightening, and the U.S. regional banking crisis has cast some investors’ attention away from emerging markets (EM). While understandable, the market’s focus on these ongoing developments has obscured – at least temporarily – the powerful trends that are reshaping the EM equities landscape. Far more than the historical economic convergence and outsourcing stories, we believe the forces behind future EM prosperity and earnings growth will be increasingly driven by the themes of innovation, deglobalization, and decarbonization.

For investors with a longer-term view, we believe the current volatility provides an opportunity to better understand – and perhaps increase exposure to – these ascendent drivers of EM growth. And while economic and market uncertainty may make it seem like an inopportune time to consider EM stocks, we believe it’s worth highlighting that high inflation, a botched policy response, and stress within the banking sector are all emanating from the world’s advanced economies. In contrast, experience has forced EM corporate managers and policymakers to allow for much narrower tolerances when confronting such issues.

Innovating their way into the future

Investors have long understood that EM countries are yearning to move up the value chain to capture a greater share of profits for finished goods. What is perhaps new is the degree to which EM entrepreneurs are harnessing innovation to address EM-specific frictions.

These innovators are racing to develop technologies and business models to address a range of barriers that have long stifled social and economic progress within these regions. Chief among these are the share of populations that are under- or un-banked and gaping holes in health care delivery systems. For example, across EMs, innovative companies are marrying financial technology (fintech) and e-commerce to provide customers with greater access to both goods and methods to pay for them.

One area where innovation has been prioritized is the push toward decarbonization, especially by China. The country is motivated not only by what it perceives as the strategic vulnerability of being dependent on hydrocarbon imports to fuel its industrial base, but also from a commercial perspective as it has positioned itself as a pivotal player in alternative technologies such as solar and batteries.

In a similar vein, Saudi Arabia has launched its ambitious Vision 2030 program with the complementary goals of decreasing its dependence on hydrocarbons and unlocking the country’s productive capabilities, which includes increasing women’s roles in the workforce. The share of female workers in the country’s labor force has risen to 34%, already exceeding the target laid out in Vision 2030. By reconfiguring the composition of the country’s economy – tilting it more toward value-added, innovative industries as well as consumption – and essentially rewriting the social contract between the state and its citizens, Saudi leadership is attempting to diversify the levers of economic growth in a world less reliant on oil and gas.

As with nearly all innovation, these initiatives will require considerable investment. For EM countries without the benefit of tapping massive cash reserves, much of this funding will be raised from developed market equity investors. Yet, unlike during earlier waves of investment flows toward EMs, this iteration, in our view, is likely to see a greater portion of profits result from commercial activity within EMs, and by increasingly sophisticated regional companies.

Reversing course

Spurred by geopolitics and a desire for supply-chain security, the multi-decade trend of globalization is reversing. Rather than flowing to the cheapest source of labor, production will instead be increasingly defined by near-shoring and friend-shoring. This is inherently inflationary. But while there are risks, opportunities for investors also exist as supply chains must be reconfigured. As multinationals seek to reduce their dependence on China, countries such as Vietnam, India, Mexico and Indonesia all stand to benefit.

China will remain an important component of the EM equities universe. Many of its industries are likely to benefit from decoupling as they seek to lower their exposure to external forces. This rationale is behind the country’s dual circulation model, which entails generating more growth from domestic sources while also continuing to supply the rest of the world with manufactured goods.

When considering China exposure, investors must understand how the government’s attitude toward – and objectives for – the private sector have evolved. Increasingly, the central government expects commercial activity to be aligned with the party’s goals of common prosperity, innovation, and decarbonization. As such, we believe investors should incorporate a governance lens to determine whether commercial initiatives in China align with those of the central government.

The long game

With the global economy slowing and equity markets volatile, one would expect riskier asset classes like EM stocks to come under pressure. And while they have lagged the broader market this year, the weakness has not been as acute as many had expected. Our view is that this is due to rising awareness among the broader investment community of the shifting drivers of EM growth. We consider these drivers secular in nature and – as evidenced by innovation – increasingly driven by entrepreneurs seeking commercial solutions to local challenges.

Inevitably, EM growth will continue to be influenced by the global economic cycle. But over the mid-term, we expect the degree to which macro factors impact EM economic and earnings growth will decrease. As this evolution unfolds, we expect investment flows to become less skittish with respect to what has historically been viewed as a riskier segment of global equity markets.

IMPORTANT INFORMATION

Emerging market investments have historically been subject to significant gains and/or losses. As such, returns may be subject to volatility.

Monetary Tightening is the action taken by a central bank to reduce liquidity in an economy, typically by raising interest rates or selling securities – steps which tend to constrict the flow of credit.