3 Ways to Help Weather Volatility in Emerging Markets

For active managers, emerging markets may provide an opportunity to weather recent market volatility and potentially generate alpha. But emerging markets are not homogeneous, and pinpointing the reason for dispersion is critical to finding opportunities.

Opportunity 1: Focusing on Countries With Easing Monetary Policy

Over the past decade, the economic performance and resulting earnings growth of emerging markets has disappointed relative to developed markets (particularly the United States).

There’s an obvious reason, in our opinion: since the global financial crisis (GFC), quantitative easing in developed markets has supported economic growth and equity market valuations, but that policy option has not been readily available in emerging markets.

That’s now starting to end. This year, we believe much of the world will be tightening monetary policy. The United States has already begun, and Europe could be next. But emerging markets are coming out of the pandemic stronger, and growth is starting to pick up naturally.

Dispersion in monetary policy cycles may give inves­tors the opportunity to add exposure to countries where an easing mon­etary policy should support growth and valuations.

As an example, consider Brazil and China, which last year were some of the worst performing markets globally.

In Brazil, valuations are already attractive in the wake of last year’s substantial derating (thanks to the Brazilian central bank aggressively raising interest rates in response to the spike in inflation). And investors are anticipating a peak in inflation and interest rates.

Meanwhile, China, which was first out of the pandemic, has already begun the process of easing monetary policy. It’s moving at a slower pace than the market hoped, but I believe that the pace of easing should accelerate in the coming months and quarters, supporting economic growth, corporate profit growth, and equity market valuations (which are currently at 10-year lows).

This dispersion in monetary policy cycles gives inves­tors the opportunity to add exposure to countries where an easing mon­etary policy should support growth and valuations, and to avoid countries where the opposite is true. Where countries are in their monetary policy cycles directly impacts the market’s perception of future economic growth and corporate profits, and, importantly, what multiples to pay for those profits.

Opportunity 2: Seeking Sectors on the Right Side of Regulation

In many emerging markets, we believe sectors on the wrong side of regulation will have a much higher hurdle to overcome because of the threat to their business models. But the opposite is also true, in our opinion.

For example, the healthcare sector in key emerging markets has also long been appealing as an offshoot of con­sumption. As people get wealthier, they want better drugs, better medical devices, private hospitals, etc. As a result, investors valued the sector as one that offered high growth and high return on invested capital. But in some countries there has been movement toward forced price reductions, and so valuations have come crashing down.

Focusing on companies in sectors the government wants to be internationally competi­tive can uncover opportunities.

There are also external concerns affecting key sectors in emerging markets. For example, if the United States decides that a particular sector in a certain emerging market is a threat to national security and puts it on the “entity list,” stocks in this sector could be derated by investors.

On the other hand, focusing on companies in sectors that the government wants to be internationally competi­tive can uncover opportunities. Electric vehicle batteries and solar power supply chains come to mind.

Opportunity 3: Going Against the Grain in Russia-Ukraine

That brings us to the question on everyone’s mind: what broader impact do we expect the Russia-Ukraine conflict to have on emerging markets and how can investors position themselves? Perhaps most notably for investors, the conflict has boosted commodity prices, and, as a result, driven up inflation globally.

Rising agricultural prices have pushed up food prices across emerging markets, where food is a much larger component of overall spending. We’ve seen how that plays out in the Middle East and Latin America, where food price increases have, in the past, caused economic and social disrup­tions. However, rising agricultural prices have benefited emerging markets that are net exporters of these commodities.

We believe Middle Eastern countries will likely be the main beneficiaries of further sanctions on Russia and the resulting upward pressure on energy prices.

At the same time, the European embargo of Russian oil and gas also has winners and losers. Russia has played a role in many emerging markets portfolios because it provides a means of gaining exposure to rising energy prices.

In light of the Russia-Ukraine conflict, however, we’ve been looking at more opportunities in the Middle East because we believe these countries will likely be the main beneficiaries if we see further sanctions on Russia and the resulting upward pressure on energy prices.

Todd McClone, CFA, partner, is a portfolio manager for William Blair’s emerging markets strategies. 

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