Portfolio Manager Matt Culley discusses how corporate priorities and growth prospects may be changing as emerging markets (EMs) adjust to inflation and a rising rate environment.
Key Takeaways
- Emerging markets find themselves tightly coupled to the current inflationary environment as supply dislocations and pandemic-related lockdowns act as opposing forces.
- In the face of inflation and rising interest rates, innovative emerging market companies have shifted priorities toward profitability and capital preservation and away from aggressive growth.
- These regions’ winning companies are likely to be the best-in-class innovators than can still deliver profitability while also investing in growth.
The commodity pressures we are seeing today started before the Russian invasion of Ukraine. They have been exacerbated by the reduced availability of Russian and Ukrainian hydrocarbons, fertilizers, wheat, and other commodities on the global market. We see this as having a particularly steep impact on emerging market consumers, as basic necessities in developing regions comprise a much larger component of the consumer basket than they do in developed markets. Stronger consumer balance sheets in developed markets also tend to help households in these regions better withstand periods of rising prices.
At the same time, China’s continued lockdown policy for COVID-19 containment and global central bank policy tightening have the counterbalancing impact of reducing commodities demand, therefore sapping some macro-dependent inflationary pressure linked to materials’ prices. Furthermore, EM countries that have reasonably high real interest rates are, in our view, better positioned in this inflationary environment than those that either started late or haven’t sufficiently tightened their monetary policies.
Inflation and Innovation
With respect to the impact inflation has on innovation within EMs, one of the major themes distilled from recent conversations with Latin American entrepreneurs was how inflation, rising interest rates and the subsequent hits to company valuations have driven a significant shift in corporate behavior. Gone are the days of 2021 when maximum cash burn fueled by extreme liquidity enabled companies to raise capital at rich valuations. Instead, companies are now focusing on contribution margins and cash preservation as the input to their business plans, with growth as an output. Last year, the opposite was true. The obvious question that arises is, what does this mean going forward for innovation as an EM theme?
With this rationalization of expenditure, we expect it is unlikely that the aggregate forward growth of innovative companies will reach previously forecasted levels. As we see the disruptive pace of innovation slow via this reduction in cash burn, it may also slow the pace of the disinflationary impact that often accompanies new technologies and productivity enhancements. Reduced subsidies and the deemphasis of certain markets is inevitably inflationary. However, perhaps one of the more peculiar outcomes is that this inflationary environment helps crystalize potential long-term winners and losers. As capital becomes more scarce, truly special business models and entrepreneurs are able to navigate these uncertain times and separate themselves from the pack. Emerging market investors should seek out companies that may be able to more substantially ramp up profitability without a materially negative impact on top-line growth.
One company that highlights this theme is MercadoLibre, Latin America’s largest e-commerce company. While a clear COVID-19 beneficiary due to rising e-commerce penetration rates, the company adeptly pivoted in 2021 – well before the market top – to a more balanced focus on profitability and growth. Over the past several years, MercadoLibre has invested heavily in building a leading logistics network, such that nearly 80% of deliveries reach consumers in under 48 hours, and 54% are delivered under 24. These are impressive statistics for Latin America. By leveraging its technology investments, the MercadoLibre is one of the rare e-commerce companies that has been able to both ramp up profitability ahead of expectations and sustain its pace of growth. Today the company has solidified its competitive advantages, generates healthy free cash flow and no longer requires the sales-based valuation multiple that was in vogue in 2021.
MercadoLibre is just one example of how innovation is alive and well across EMs. The winners are quickly being differentiated from the losers. In this environment, being active investors matters.
A Longer View
On a more thematic and long-term front, current supply side disruptions are coinciding with a generational shift in the importance of some commodities. We recognize the power of decarbonization as both a societal and investment theme, but what has become even more important, in our view, is the value of the commodities required to achieve a green energy transition. Copper has been a key theme we have followed for many years, but we are now seeing a broadening of the relevance of the entire metals complex.
The shift to electric vehicles continues to surprise the market, and many of the largest vehicle manufacturers are becoming increasingly focused on ensuring low-cost supply as a strategic priority. We have seen CATL, the largest battery manufacturer in the world, move to vertically integrate by acquiring a stake in Indonesian miner Merdeka Copper Gold. Only recently, Indonesian President Jokowi was in Texas meeting with Tesla CEO Elon Musk. The impact of shifting sources of demand, pandemic-related supply disruptions and the Russian invasion of Ukraine has highlighted the strategic importance of securing the supply of key commodities such as copper, lithium, cobalt, nickel and aluminum.
While global macro events will undoubtedly move the goalposts for near-term demand, we see the value of key industrial inputs increasing over time. In our view, the most promising opportunities can be found by identifying high-quality assets that are low on the cost curve, at companies with strong corporate governance in jurisdictions that are favorable to shareholders.
Foreign securities are subject to additional risks including currency fluctuations, political and economic uncertainty, increased volatility, lower liquidity and differing financial and information reporting standards, all of which are magnified in emerging markets.
