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The case for investing in
smaller emerging and frontier markets

May 14, 2018
By Samuel Vecht, CFA

In the last in our series of emerging market briefings, Sam Vecht, Head of BlackRock’s Emerging Europe and Frontiers Team, discusses why moving beyond common EM exposures and allocating to smaller emerging and frontier countries may add increased alpha opportunities and help lower portfolio volatility.

Q: What’s the case for moving beyond the big EM countries and into smaller emerging and frontier markets?

A: I like to think of emerging markets as being divided into Everyone's Eight and the Forgotten Forty. If you look at where investors are putting their money, approximately 85 percent of it is in eight countries: China, Korea, Taiwan, India, South Africa, Russia, Brazil and Mexico, according to 2017 data from Morningstar.

Meanwhile, the other countries in the emerging and frontier universe—which includes places as diverse as Argentina, Indonesia, Nigeria and Turkey—are broadly ignored. While we see interesting opportunities in both Everyone’s Eight and the Forgotten Forty, we believe there are some potential advantages to investing in the latter.

Markets in these countries are often driven by the local economic environment rather than by global trends, so if you’re looking for portfolio diversification, we think they are well worth considering. And because these markets haven’t garnered much attention from global investors, they may also be less efficient, so we think they provide interesting opportunities for active managers to add alpha.

Q: What does the current environment look like in EM and how does that compare to developed markets?

A: We're at the early stages of the cycle in emerging markets. The bull market in EM began 18 to 24 months ago, while the bull market in the developed world began more than nine years ago. So EM is at a very different point in the cycle.

In much of the developed world, rates have been ultralow for most of the past decade, and that has, of course, encouraged many companies to increase their debt loads. That can work out well for investors if companies spend those funds wisely, but past experience has taught us that not all companies do.

In the emerging world, rates have not been so low. So companies have had to be more thoughtful about whether to take on additional debt and about how to utilize their cash flows. Therefore, broadly—not exclusively, but broadly—we feel that emerging market companies have been more sensible than many of their developed market peers over the last decade.

I’d add that the different interest rate environments in EM and DM have also affected stock market valuations. In the developed world, central banks pushed investors into riskier assets like equities by driving rates to such low levels, but that didn’t happen in EM. So it should come as little surprise that many developed markets are now sporting valuations well above those found in emerging and frontier markets. See the chart.

Bargain hunting

P/E ratios for MSCI World, MSCI EM and MSCI Frontier Markets Indexes

Bargain hunting

Source: Bloomberg, March 2018. Indexes are shown for illustrative purposes only. Indexes are unmanaged. It is not possible to invest in an index. Past performance is no guarantee of future results.

Q:  What are some of the risks that could derail the EM story?

A: The risks that I'm most concerned about are actually coming from the developed world. Rates are rising in the U.S., and the ECB will eventually have to come away from zero and sub-zero policy rates as well. Thus far, markets have reacted well to rising rates, as the pace has been gradual and well-telegraphed. If this should change, and rates start to move higher at a faster pace than investors are forecasting, that could lead to a repricing of many risk assets, including emerging equities. I’d also add that the political situation in the developed world, with the rise of economic populism and the threat of trade wars, poses risks to the emerging world as well.

Q: What about volatility, aren’t some of these far-flung markets quite volatile?

A: On an individual country basis, absolutely, many frontier markets have exhibited high volatility. But once you start to build a portfolio that includes many different frontier countries, something interesting happens. Because these markets are driven by local dynamics—what’s driving stock prices in Bangladesh has little to no correlation with what’s driving them in Nigeria—a frontier markets portfolio may actually be significantly less volatile than an emerging markets portfolio, or even a diversified U.S. portfolio. See the chart.

All quiet on the frontier

Weekly volatility of frontier, developed and emerging indexes

All quiet on the frontier

Sources: Bloomberg, MSCI, March 2018. Volatility of weekly returns since January 2011. Indexes are shown for illustrative purposes only. Indexes are unmanaged. It is not possible to invest in an index. Past performance is no guarantee of future results.

Q: You’re investing in more than 40 countries with thousands of securities to choose from, what makes a particular company or country stand out?

A: I think one has to look for three things: cheap equities, cheap currencies, and countries where GDP is not growing too fast. We just talked about equity valuations, and I think they’re generally supportive of emerging and frontier investing currently, especially compared to developed markets.

Currency moves can play a big role in driving the returns of overseas investors, so it’s imperative to factor currency valuations into your investment analysis. There are a few EM currencies that appear overvalued today, but we think the majority of them look fairly valued.

As far as GDP growth, our view to be wary of countries where GDP is growing very rapidly may seem counterintuitive. But if economies grow so fast that CEOs start overinvesting and government policymakers think they can ignore Economics 101, that can be a dangerous environment for investors, and it’s one that we’d like to avoid. Because we’re still in the early stages of the cycle, we’re not seeing that type of behavior, but it’s something that we’re always on the lookout for.

Q: It sounds like the dynamics in EM and DM are pretty different, what about the investment process?

A: In general, the process is similar. We insist on traveling to the countries in which we invest. We insist on meeting the companies, their customers, their suppliers and, most importantly, their competitors, because competitors can provide insights that, frankly, you just can’t get from the companies themselves. And the fundamental analysis that we perform is very similar to what we would be doing if we were investing in developed Europe or the U.S.

But there is one big difference: I think you need to have a higher degree of caution and skepticism about the ability of companies to deliver on their plans, because, historically, many of them haven’t. You really need to understand if a company is being run for the benefit of minority shareholders, or if it’s being run primarily for the executives or the state.

Because of these uncertainties, it’s critical in EM to get the top-down view right, as well as the bottom-up view. For example, correctly forecasting political developments in Russia is considerably more important than it is in Denmark.

Q: Which countries concern you at the moment and why?

A: Turkey and the Philippines strike me as two countries that one should be concerned about. They've both got current account deficits that are increasing and inflation that's higher than forecasted. As a result, their currencies could come under meaningful pressure, and their equity markets do not appear particularly cheap by historical standards.

Q: On the flip side, which countries are you positive about?

A: There are quite a few. Given where we are in the cycle, I think Indonesia, Thailand and Korea appear attractive. Korea is a particularly interesting case. For the first time in 70 years, it looks like the president of the United States and the president of North Korea will be meeting face to face. I don’t think markets reflect the potential positives that could come from improved relations between these two historical adversaries, or between North and South Korea. That strikes me as a really interesting opportunity.

In addition to those Asian markets, there are interesting opportunities in Greece, South Africa, parts of the Middle East and Brazil. There is a wide swath of emerging markets where we believe the cyclical opportunities are attractive.

Samuel Vecht
Head of Emerging Europe & Frontier Markets
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