Podcast with Emily Fletcher Co-Portfolio Manager

Oscar Pulido: Welcome to The Bid where we break down what's happening in the markets and explore the forces changing the economy and finance. I'm your host, Oscar Pulido. What's the difference between developed, emerging and frontier markets? How do differences in per capita wealth, technological advancement, and liquidity affect the investment opportunities across these various economies? Here to shed some light on this topic is Emily Fletcher, portfolio manager from BlackRock's Fundamental Equities business. Emily will highlight some of the risks and opportunities that emerging markets present and provide her observations as an investor who is meeting with companies and handpicking stocks across the world's developing economies. Emily, welcome to the bid.

Emily Fletcher: Thanks so much for having me, Oscar. It's great to be here.

Oscar Pulido: So, Emily, maybe we could start with a simple definition, emerging markets and developed markets, we hear these terms a lot in investing, what's the difference between the two and then why is it so different to be investing in emerging markets?

Emily Fletcher: I think there's a bit of a misperception around emerging markets that they're countries that are less economically developed and poorer than developed markets. And whilst that is true for some countries such as your India or your Indonesia, which do have a much lower GDP per capita, it's not at all true of countries such as Qatar and the UAE, which are some of the richest in the world. It's also not really about level of technological development. Korea, for example, is extremely developed from a technological perspective. Actually, definition of emerging markets is all about the level of development of the stock market, its settlement custodian, currency trading systems. Countries are analyzed and they're split into two buckets. Those that have the most developed systems in place, classified as developed markets, and those with less comprehensive trading systems classified as emerging markets. Also, I think in the majority of cases, there tends to be a difference in the level of institutional development between emerging and developed markets with the institutional frameworks stronger within developed countries. In terms of what really sets apart emerging markets from developed markets, I think it’s the complexity, the volatility, and the dispersion that we see across the universe. In terms of complexity, we're talking about 25 countries, each of their own political and economic cycles. They all have their own currency and bond markets. In aggregate the markets trade for 20 plus hours a day over six days a week, whereas developed markets tend to have harmonized economic cycles. In terms of volatility, emerging market index has had a peak to trough move of more than 20% in 19 in the last 20 years. And on top of these index level moves, we see huge dispersion between stock performance. Typically, two thirds of the stocks with emerging markets move more than 40% in each year. So, this makes it a really fantastic place to be an active investor because you'll get an opportunity to buy most companies at some point during each year. I think there's a perception that high volatility is a negative feature for emerging markets. The historic emerging market narrative was that countries would grow faster than in developed markets and given how deeply cyclical all of the emerging markets are individually I think this illusion of smooth growth was never an accurate portrayal. Instead, what we really have is a wild, exciting, volatile hunting ground for active investors who can benefit from the complexity of 25 nonsynchronous markets, offering 4,000 highly diverse stock opportunities.

Oscar Pulido: So, you mentioned a few things there, and maybe just to recap, while the term emerging markets is one terminology to describe all these different countries, they can be very different. Some on a per capita basis are poorer, some are actually quite rich. The stock markets could behave very different from the economies. There's a lot of volatility, which I think for you as an investor represents good opportunity. We've heard from Wei Lee, our Chief Investment Strategist at the BlackRock Investment Institute, she's talked about how emerging markets are an interesting, investment opportunity, part of the reason being that coming out of the pandemic, the central banks in these countries were quick to raise interest rates and perhaps they're towards the end of that rate hiking cycle. So, talk a little bit more about what other reasons are there that excite you about emerging markets?

Emily Fletcher: Yeah. First to just follow up on Wei Lee, was saying, I agree. Inflation did start to rise in emerging markets and developed markets about the same time, so beginning of 2021. But interestingly at this point, the emerging markets generally started to hike interest rates, but in developed markets, we didn't see them start to hike until about a year later, so early 2022. And emerging markets have generally continued to hike interest rates since then. So as a result, for most of the countries in emerging markets, interest rates are now higher than inflation. Most of them have a positive real interest rate. And this early increase in those rates has meant that in some countries, particularly those in South America, we have seen an economic impact already feeding into the economies. And we've seen that slowdown in economic activity already happen in these countries, as we are perhaps worried about in more of the developed markets now. When we went through Covid, developed markets such as the US the governments were able to give their population some handouts. And that was something that we didn't see in emerging markets to the same extent. They just didn't have the same capability to replicate that and in a way that has some benefits for emerging market now, because we are seeing lower second round impacts going into inflation to the point where we think inflation has fairly clearly peaked across the majority of emerging markets. So emerging markets, they started raising interest rates first, and they're likely to be the first to cut interest rates. And as those interest rates come down, then we should see consumers and companies that will end up with more money in their pockets as the cost of debt becomes cheaper and we should then see growth accelerate across emerging markets. And that turning point is normally a time when emerging market, equity markets, start to do quite well. And it's a good time to think about investing into these countries on the back of that cyclical activity pickup. I think another area to comment on would just be the huge credit expansion we've seen in China year to date. So, in the first quarter, China added total social financing of about $2.1 trillion, and that's something like adding the entire Indonesian banking system every month in terms of size. We did see significant slowdown in Chinese economy last year as they battled covid but with this credit extension, and we think we, that should really drive significant benefits with reopening, particularly with this liquidity we're expecting transaction volumes and values in the property market to pick up, and then as consumers feel wealthier for that wealth effect to then trickle down into growth in a lot of Chinese consumer areas. I think another area is just around margins, so emerging markets have really progressed from copying to innovating to in some areas now actually being global leaders such as electric vehicles or leading-edge chip manufacturing. And these are areas where we now see higher margins in emerging market corporates versus their developed market peers. So far, this isn't the predominance of emerging market investing and the aggregate margin difference across emerging and developed markets still remains high, but it would be really interesting if we could see any closure of this gap in the future, which would then mean that emerging markets, which are currently trading on trough from very low earnings, could arguably look really interesting from a valuation perspective. Finally, I think it's just important to think about liquidity. For the majority of my career, emerging markets have been fairly out of favor, and as a result of that, I think we have seen liquidity come down in terms of the volumes that are traded on emerging markets, stock markets. There's a lot of commentary at the moment that, investors are looking for the Fed to stop hiking, looking for a pivot, and post that, they'll start looking at emerging markets, but I think we do need to remember that liquidity is low in these markets and sometimes it's actually hard to buy post-event when everyone is trying to move in the same direction.

Oscar Pulido: So, Emily, you've painted a really interesting background of the opportunities in emerging markets. I heard you mention profit margins are lower than in some of the developed markets, like the US, you’ve talked about companies that are, becoming innovators and leaders in their space. You also mentioned China. I think the amount of stimulus that China has enacted being the equivalent of the banking system of Indonesia, it feels like you could spend all your time just looking at investment opportunities in China as the largest emerging market but talk about maybe what other countries are of interest to you.

Emily Fletcher: Yeah, I wanted to pull out a couple of opportunities here actually. And the first one of them would just be Indonesia, which is a country that we think has seen a fairly substantial improvement in its economic outlook over the last few years. Indonesia's the world's largest exporter of nickel. Historically, nickel was predominantly used to make stainless steel, but by 2030, we think nickel will predominantly be used to make batteries for EV cars. So, Indonesia in 2020 exported nickel to the of about 12 billion. by 2025, that'll be $45 billion, already a pretty substantial growth. Now it's a country that historically has borrowed from abroad, it's run a current account deficit to finance its domestic growth. But the size of the increase we're seeing in those nickel exports is such that that structural current account deficit was about 3% of GDP pre-covid. It's already shrunk by about one to one and a half percent of GDP. And we think it will do the same again over the next couple of years. So that should have the benefit of making Indonesia much less reliant on borrowing from abroad and needing to attract foreign capital. And that should result in improved domestic liquidity in higher domestic economic growth. The cost of borrowing in Indonesia should come down slightly, and the volatility and currency movements in Indonesia should reduce a bit, and that should make Indonesia a much more attractive investment destination. And another country I'll pull out is very much a cyclical opportunity. But I think Brazil stands out at the moment. It's a country in the world, with the highest real interest rates. So, interest rates are very high, despite the fact inflation peaked in March, the economy at the moment has slowed. Brazilian companies and consumers have struggled with that really high cost of debt. And part of the reason that rates have been so high is that investors have been concerned, post the election of Lula as President in Q3 last year, that his administration would pursue very expansionary fiscal policies, but this really hasn't been the case to date. And as we go into the second half of this year, Brazil's likely to be in a position where the central bank could cut interest rates. As they do the pressure on companies and consumers will ease and we should see an acceleration of growth and that is a market that's currently trading around historic trough valuations, so I think potentially a cyclical opportunity there.

Oscar Pulido: When you talk about some of these individual countries you've mentioned the exports of nickel will be very helpful to Indonesia, so does that help every single company that's trading in Indonesia or does the economic backdrop in Brazil help every single company? Or do you then have to dig in and really sort of identify the winners and losers from that economic backdrop?

Emily Fletcher: Mm, so emerging markets is really about pulling together all the sources of information. So, what is happening in a country, those trends I talked about in Indonesia and Brazil are really important in kind of setting the backdrop for where you should be looking for stock opportunities. Then it's about digging in, as I said, it's about 4,000 different stocks within emerging markets that will all have their own specific company drivers. and all trade again with additional dispersion on top of that. So, you can see that that is just a huge amount of information to pull together, and you really want all of it to be pulling favorably, to be finding the best opportunities, so to be a great company, a great stock in a great market, and to pick it just before the turning point and then you can do really well. And that need to have all of those boxes ticked, I think is again, what makes emerging markets so interesting from an active perspective that you can, really find some interesting opportunities in and amongst.

Oscar Pulido: And Emily, it turns out you have a special expertise in frontier markets, so help us understand what is the difference between an emerging market and a frontier market?

Emily Fletcher: So, I really see Frontier markets as a sub-category within emerging markets. If we go back to thinking about the difference between emerging markets and developed markets, being around the level of development of the equity markets, frontier markets is really just a step down from that. It's the set of markets that are even less technologically developed than emerging markets, or it can be the set of markets, that trade with lower liquidity than emerging markets, so where you see a much smaller volume of trades executed over any given year. And actually, what's been interesting over the last 10 years since I started looking at frontier markets is that we have seen quite substantial technological advancements in a number of stock markets, that would've historically been considered frontier markets such as Saudi Arabia or Qatar, and very much now promoted to become emerging markets.

Oscar Pulido: I think there's a reputation amongst these emerging and frontier markets of high volatility and in fact, you touched on it in some earlier comments about these big swings in stock markets that you see. How do investors manage these dramatic ups and downs?

Emily Fletcher: I think that's a very fair point to pull out and especially in some of these smaller markets in and of themselves they can be inherently and deeply risky and volatile. But one of the really interesting things about these smaller markets particularly is that if you create aa basket of them put together a portfolio of them, you actually generally end up with something that in aggregate is much less volatile than if you were to look at emerging market indices at that level. And it's a really interesting one, but they actually are still places in the world where you can find diversification. In these smaller markets and tends to be the smaller you, get with markets, the more there's a dominance of local political and economic events, and those events tend to impact performance more. There are generally minimal trade flows between smaller, emerging and frontier countries, so problems in the real estate market in Vietnam will tend to have no impact on the level of oil production in Argentina. Recent election in Thailand had no impact on the subsequent Greek election. Constitutional change in Chile won't impact interest rate movements in Saudi Arabia. So, it's very interesting that you still have huge benefits of diversification from looking at some of these smaller markets.

Oscar Pulido: So, you, mentioned that you're an active investor, which means you're picking individual companies in each of these emerging and frontier markets and part of being an active investor, I imagine, is you're visiting these countries to be on the ground to understand what's going on in, the local economy. So, what are some of these countries you've visited and any good stories about some of your recent visits?

Emily Fletcher: So, I've been to about 35 emerging market countries now. Actually, I always find it rather unnerving traveling with security. I think it's having grown up in the UK I'm not used to seeing guns around at all. Luckily all the guns I've seen on my travels have been those held by my security detail. But there was one time in Nigeria where I was followed by Security on a track with, probably the largest sort of sub-machine guns I've ever seen that I did find a little bit unnerving. I did get the opportunity once to visit the Zimbabwean Stock exchange while it was still using an open outcry system, which was absolutely fascinating to see but is now transitioned to a fully electronic system. Otherwise, I reckon I probably could have a successful second career as a travel agent. I would highly recommend visiting the mountains in Oman, the Polo Club in Lahore, Pakistan, the dead cow oil fields in Argentina, and there's some fantastic palm trees inside the Central Bank of Kuwait. My favorite food comes from Vietnam, but the best meal I've ever eaten was in Mexico.

Oscar Pulido: I thought I had some interesting stamps in my passport, but I'm realizing that it probably pales in comparison to yours. Emily, thank you for giving us this tour of, emerging and frontier markets and thank you for joining us on The Bid.

Emily Fletcher: Thank you. It's great to be here.

Oscar Pulido: Thanks for listening to this episode of The Bid. On the next episode, we will consider the world of cash investing and the opportunity for investors in an environment of higher interest rates. Make sure you subscribe to the bid wherever you get your podcasts.