Episode 18: Don’t Get Complacent in Emerging Markets

The index comprises 26 countries with their own politics, monetary and fiscal policies and GDP growth drivers. But there are also strong, resilient companies in most of them and plenty of potential upside for returns.


Don’t Get Complacent in Emerging Markets

Josh Rubin: We talk about emerging markets as being a single asset class, but emerging markets do comprise 26 different countries, each with different politics or monetary policy or, or GDP drivers.  Because of the natural and inherent risks that are in emerging markets, the, the first part of risk management for us is finding companies that we can withstand all these different forms of volatility or risk.  We can refer to them as strong companies, but what we really think of is companies that have a market position where even if the market gets softer or there’s an external event negatively impacting the market, the company is strong enough to survive that unanticipated external risk.

Charles Roth: Hi.  Welcome to Away from the Noise, Thornburg Investment Management’s podcast on key investment topics, economics and market developments of the day.  I’m Charles Roth, Global Markets Editor at Thornburg.  We’re joined by Josh Rubin, who co-manages our emerging market equity strategies.  Welcome Josh.

Josh Rubin:        Thank you Charlie.  A belated Happy New Year.

Charles Roth:    And to you, as well.  So the last time we had you on Away From the Noise in June, we discussed India’s digital transformation and a number of structural reforms that have effectively enabled India and many other emerging markets to essentially leap frog a lot of costly infrastructure spending, for example, wireless broadband over wire line, and despite having neither the fiscal resources of the U.S., Japan, or or Europe, or the monetary ability to push their domestic policy rates to zero in the fight to mitigate the economic damage from COVID, emerging markets did quite well last year.  Emerging market economies are estimated to have shrunk just under 1 percent and are forecast to grow 5.1 percent this year, unsurprisingly led by China.  That compares to a 5.1 percent contraction last year in advanced economies, which has seen rebounding 4 percent this year.  Interestingly, both the MSCIEM Index and the S&P 500 produced a total return in 2020 of just over 18 percent, but in the first 3 weeks of January, as we’re recording this podcast, the M Index as so far tripled the returns of the S&P 500, which seems like a good omen.  What’s your outlook generally for emerging market economic growth, as well as equity returns this year?

Josh Rubin:        Absolutely.  And I think overall what you just shared is a good summary both for how things progressed through 2020 and especially as we got into late 2020 that sets the stage well for, for the outlook for 2021.  More than anything, right now it’s a little bit of back to the future where our expectations for 2021 look very similar to what our expectations were for 202 at this point in the year last year, with the big change being the interruption from COVID.  You mentioned that last time we talked was, was June of 2020 and we talked about digitalization and then some of those trends, and, and those are major trends that are very important, but they also were a little bit of band aid adaptation during the course of 2020, and now we’re back to more of the big underlying trends in emerging markets as opposed to how to navigate a complex situation.  So the key things that I would say for our outlet or for how we think about stability or opportunities in emerging markets is structurally emerging markets naturally have a lot of attractive drivers.  Their capital markets continue to broaden and deepen, their consumption trends also continue to broaden and deepen, and new types of products and services continue to penetrate the economies, and, and that’s really driven by increasing economic formalization across these countries.  At the same time, there are a few types of cyclical factors that tend to interrupt either growth or investor sentiment, and most notably among these would be rising interest rates which tend to lead to a strengthening U.S. dollar and/or weakening emerging markets currencies, commodity price volatility, which, in some emerging markets can impact consumption because consumers are squeezed by commodity prices, which in other emerging markets they can be a challenge for, for the overall macro because those countries might be more dependent on commodity exports, and then the final piece would be sort of political stability, sometimes driven by domestic politics and emerging markets, but oftentimes driven by broader geopolitical trends.  And as we exited 2019 to enter 2020, we thought we were in a very good situation for each of those.  The U.S. and China had agreed on general terms of trade that we thought, uh, created some stability, or at least the opportunity for things to stop getting worse between the two largest economies in the world.  We also had seen from the fed clear communication that the fed was done raising rates and potentially could start lowering rates, but again, just the end of rising rates is a tail wind for emerging markets, and then finally, commodity prices appear to be pretty stable with a little bit of a cyclical tail wind entering 2020.  COVID didn’t really change the U.S.-China relationship from a trade perspective, but it certainly disrupted global politics and COVID also changed the interest rate environment and, and the commodity environment.  Today, commodity prices generally are, are back to around where they were a year ago.  We have a lot of visibility that interest rates are favorable for emerging market economies for the foreseeable future.  Regardless of one’s personal politics, we have visibility of what the Biden administration would like to achieve so we don’t see major disruptions on the political front.  If those three factors are out of the way or can sort of put them to the side relative to the way we think about emerging markets, suddenly we’re back to looking at attractive underlying structural growth which is higher than we in developed markets and that, that tends to create a lot of attractive investment opportunities.

Charles Roth:    It seems like a number of portfolio managers share that view, at least according to Bank of America, Merrill Lynch’s latest monthly global fund managers’ survey showed a, a record net 62 percent of whole global money managers said they were overweight EM and two-thirds predicted that EM will be the top performing asset in 2021.  Fund flow data also reflect the bullishness about EM prospect.  I’m wondering how you view those sorts of data when, when you see them.  Is it a crowded trade, is there room for everybody to get, to get in?  How do you navigate rising markets in EM?

Josh Rubin:        Absolutely, you’re, you’re right to say that the 26 countries that comprise emerging markets have been a lonelier place to invest than Silicon Valley over the last 5 or 6 years, but we, we don’t think it’s too late.  We don’t think that the last 3 or 4 or 5 months of strong performance from emerging market stocks mean suddenly we’re past the good part of the story.  We, we would say we’re still pretty early innings in all of this.  And, and there’s a couple parts of it, number one, e, even though flows have been strong or you mention, global investors moving to some overweight positioning more recently, flows have definitely lagged into emerging markets for the first 5, 6, 7 years.  There’s definitely more to come than just a few months to make up for a, a low level of interest in emergency markets for a pretty long time.  But secondly, I think there’s two different ways to think about the opportunity set in emerging markets right now.  Number one is the cyclical opportunity, and number two is the structural opportunity.  From a cyclical side, well what does make sense to me is that most global economies were depressed in 2020, there’s a natural recovery in 2021, and you can sort of look around the world and see where equities did or did not price in some of this recovery.  For emerging markets to be at a place where investors wanna move because they say, hey, the recovery prospects have not been fully priced in yet, I think that makes sense and, again, that’s an early part of the total trade, because there is still a lot more economic recovery to come in the next several years and valuations would say that the full recovery has not been priced in.  The second part of it goes back a little bit to my last answer, which is even once a cyclical recovery normalizes or sort of we get to balance, there are still a lot of opportunities that are, that are just the normal opportunities set in emerging markets that maybe people wouldn’t wanna invest in when they were worried about currency depreciation or they were worried about interest rates rising, but if we can say that global liquidity will be strong, currencies will do what they, but there, there shouldn’t be cause for major devaluations against the dollar or the Euro.  Suddenly, people can be thinking a lot more about not just the big dumb recovery trades, but much more of the surgical opportunity of just where there’s great companies, maybe they’re executing a turnaround, maybe they have depressed earnings because they’re investing in a growth project that’s about to come through, or maybe they’re pretty consistent earners in the way the business operates, but there’s a lot of surgical opportunities for emerging markets investors or global market investors to participate in emerging markets, even once the cyclical recovery plays out.

Charles Roth:    You mentioned a few things there that probably deserve some unpacking, consistent earners, other are cyclical recoveries, which brings up the question of the volatility that you often see in emerging markets pre-COVID, certainly over the history of asset class.  In other words, in developed markets we’re hearing a lot now about growth to value factor rotations, but in emerging markets those have been quite frequent and several times over the course of a single year, not to mention a decade or a half a decade, how, how do you manage the volatility within that asset class?

Josh Rubin:        Volatility is probably the number one concern for most investors when thinking about participating in emerging markets.  The economic side of these countries is generally not nearly as big a concern as the equity swings that can happen like you said, on a short-term basis ore a longer-term basis.  And the cause for this is by definition these are less mature capital markets, they often have a smaller institutional investor base, i.e., sort of institutional investors have a long time horizon than retail investors, there’s not the same type of investor support to create some equity stability.  The countries do often have higher economic cyclicality than the U.S. or Europe, currencies will be more volatile, so you, you have to think about each of these elements and how to address them to sort of have a smoother ride when participating in emerging markets.  The big thing would be, especially related to less mature capital markets, that how flows can create bigger short-term swings.  If people decide, uh-oh, it’s, it’s a risk off globally, you know, I wanna trim some of my high yield bond position and I wanna trim some of my emerging markets equity position, that can lead to that equity volatility that like you said, can swing value or growth within those markets in a short period of time.  For us, the way we try to address this, is, is really saying we don’t wanna make a one-way bet on anything.  What we do wanna do is generate alpha from stock selection, but we wanna generate balance and a, and a smoother ride that investors can sleep with at night through portfolio construction.  And so we actually try to have a balance of growth companies and value-oriented companies in the portfolio.  That way, when there are market swings from value to growth, also market swings between types of, of countries or macro factors that might drive the markets in a certain way, hopefully that leads to a portfolio outcome with less volatility and, and that way investors can just participate in emerging markets through the entire cycle rather than thinking of it as risk on or risk off.

Charles Roth:    What are some of the risk on your radar that you’d kinda wanna be cognizant of?

Josh Rubin:        It’s a complex answer that I will, I’ll try to make simple, but the reasons it’s a complex answer is, again, we talk about emerging markets as being a single asset class, but emerging markets do comprise 26 different countries, each with different politics or monetary policy or, or GDP drivers.  Because of the natural an inherent risks that are in emerging markets, the first part of risk management for us is finding companies that we can withstand all these different forms of volatility or risk.  And we, we tend to refer to them as strong companies, but we really think of is companies that have a market position where even if the market gets softer or there’s an external event negatively impacting the market, the company’s strong enough to survive that unanticipated external risk.  We also generally look for companies that, that have strong balance sheets, and the reason is a difference between emerging markets and developed markets is the correlation of equity capital markets and bond capital markets.  In, in the U.S., for example, generally the economy gets worse and interest rates go down, and therefore, if a company’s a little bit stressed, it actually has a lower borrowing cost than it did when times were good.  In emerging markets, because they’re less mature, often what happens is times get tough, global investors might flee, and therefore, fixed income markets close down in the same way that equity markets close down, so times get tough and companies find themselves having higher borrowing costs rather than lower borrowing costs like we see in developed markets.  So for us, thinking about companies with strong balance sheets is really important because that’s actually a competitive advantage.  We’re looking for companies that generally do well in, in up cycles and do, and come out even stronger from a down cycle.  The risks we see are definitely more dependent by region of the world today, as opposed to just a broad brush stroke on emerging markets in total.  What we see is, you know, if we were to say, where were we 6 months?  We had more comfort in the macro and policy backdrop in Asia than we did in Europe or Latin America, and today, in part because of the COVID vaccine, in part because we, we think we know where monetary policy is, and, uh, and government policy is, we feel pretty good about the macro backdrop across three parts of the world, but depending on the macro backdrop is also part of what would make someone decide what type of company profile they, they wanna be investing in.  If you’re worried about the macro so you can’t really count on external demand or external drivers to support the fundamentals of a company, you’re likely to wanna lean into a stronger growth type of company, because you’re, you’re leaning into a company that you think can grow through the down cycle, whereas a company that has more external sensitivities, you need an upcycle to drive its recovery.  And so I think going back also to this question of value and growth, it’s a lot easier around the world for people to lean into growth companies when they’re worked about the macro because the idea is if I own the growth company, I don’t have to worry about the macro.  When we look around emerging markets today and sort of balancing these risks, again, we, we were avoiding macro risks in some parts of the world 6 months ago.  Today you were more comfortable taking macro risk, which means we’re, we’re still comfortable balancing value and growth companies across the world.  The third thing that we tend to think about for risk management is, is what that currency risk is for our investors who are generally U.S. dollar investors, because it doesn’t do anyone any good if a company grows earnings 20 percent in the local currency, but the local currency depreciates 20 percent until there’s, there’s no actual earnings growth in, in the U.S. dollar.  And so to balance that, we’re not trying to be currency traders, we’re not trying to make an explicit call on, on the direction of a currency in the short term, but we do look at some common drivers of currency moves to make a prediction about the, the base case level of currency change over, over the next several years.  And, you know, that includes inflation differentials, budget deficits, monetary policy, things like that.

Charles Roth:    You don’t really see currency risk as a near term obstacle given that we’re currently in a world of zerp or nerp in the advanced countries, including the U.S. where the fed has made clear that if would like to keep monetary policy exceedingly accommodative, at least until 2023 if not through 2023.  So that head wind has, has actually dissipated at, at least for now.

Josh Rubin:        That head wind has absolutely dissipated for now, but with that said, being an emerging markets investor, in part means the vigilance never stops, and so even though we would agree with you that a number of the countries that typically we would expect some depreciation are less likely to have that depreciation in the, in the next couple years.  Generally, we’re still gonna be more conservative rather than less, because if it’s not COVID it’s who knows what.  A really key thing for risk management in emerging markets is don’t get complacent, but I, I do agree with you that overall we, we feel much better about the outlook not being a head wind, but we’re, we’re still gonna be practicing discipline ra, rather than, uh, you know, throwing caution to the winds, even with the current environment.  The final piece that I’ll mention for our risk management, and I’ll keep it short, but it, it ties together with our definition of strong businesses but in a different way, is we, we do have a form of ESG integration in our company analysis.  This is not a product that has a negative overlay or simply says we won’t invest in sin stocks or in overlay or simply says we won’t invest in sin stocks or in oil companies.  Uh, we, we do think about carbon, but we think about many of the other factors that go into ESG because generally those are characteristics well-run businesses.  So, um, we, we have a level ESG integration which helps with our IEB generation and it does help with our risk management, as well.

Charles Roth:    So your strategy isn’t formally classified as ESG, although I would imagine that the G governance aspect has always been front and center in your research.  Can you talk a little bit about that and especially how you have included environmental and social considerations into the mix?

Josh Rubin:        As you say, the G has sort of always been an important component of our identification of strong businesses, because we need management teams and corporate governance policies that are transparent enough and predictable enough that we really can trust these management teams to navigate all the complexities of operating in emerging markets.  But over the last 4 or 5 years, we, we’ve evolved in our understanding of the S and the E part of it and how those things are, are important for what we do.  It’s sort of a, a combo corporate governance and of social elements to think about the sustainability of how employees are treated or how the supply chain is treated, but just for an example, we own a retailer in Mexico, and that retailer sources goods from Mexico, but it also sources goods from around the world due to the nature of, of globalization and we, we investigated the supply chain and, you know, one of the things we learned is there are sort of employee abuse practices they have in place that they, that they make all of their suppliers be trained in, that they have posters in over 20 languages because of what the supply chain is that say if you’re employer’s not treating you well, let us know.  And, and the reason that’s important is we would naturally be investigating the supply chain to understand the company’s competitive advantages, but historically, we might have only been thinking about the cost factor, sort of can they get the lowest prices on whatever it is they’re selling?  The underappreciated element that’s sort of a risk management tool when you look forward is if somebody’s supply chain does include the equivalent of modern slavery or, or child labor, and suddenly in the future they need to totally change their supply chain to adapt to, you know, some global regulatory environment, maybe their competitive advantage goes away because they, maybe they had a competitive advantage against their peers because they were using a less ethical supply chain.  But if, if we can investigate the supply chain today to confirm the, the nature of it and ensure it’s really a sustainable set of business practices, then we know that we’ve, well, we have identified as a competitive advantage for them is sustainable and, and that can lead to, again, that opportunity to continue growing market share for the long term.  And so whether we think about governance or, again, environmental factors, just to give you a different type of example, um, some oil companies are very dirty, they don’t care much about environmental remediation, and, and others are not.  And so if you can look at two companies and you can say these both have very similar cost structures or profit opportunities, but one of them has a far bigger risk of, of getting a, a $1 billion fine because of of a spill because they’re not taking the proper precautions, you’re actually reducing future risk and you’re, you’re improving your idea generation.  We do think it’s important to be good stewards of, of the environment and good corporate stewards, but there are real elements of ensuring that whatever it is you think you’re investing is more sustainable for the long term by doing the ESG work up front, even if it’s not an ESG strategy.

Charles Roth:    Well, that’s very interesting.  Thank you, Josh, for joining us today

Josh Rubin:        Charlie, it’s always a pleasure to talk and I, I hope we get to talk in person sometime soon.

Charles Roth:    Likewise.  Thank you.  Today’s episode was produced and edited by Michael Melton.  You can find us on Apple, Spotify, Google podcasts or your favorite audio provider by visiting Thornbug.com/podcast.  Subscribe, rate us, leave a review.  Please join us next time on Away From The Noise.

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