By the Redwheel Emerging & Frontier Markets team
For the better part of the past decade, emerging markets have been out of favour with investors. But the current sell-off is approaching an end just as global demand for ‘transition’ metals takes off. It means emerging markets may have reached a turning point, and it’s up to savvy investors to take advantage.
Emerging market indices have performed poorly over the past 10 years, acknowledges Redwheel Co-Head of Emerging and Frontier Markets, James Johnstone.
Speaking in Sydney in November 2022, Johnstone said that growth in the sector began to stall towards the end of the 2010s – largely as a result of fiscal tightening in China and recessionary conditions in Brazil. For many investors, the slowdown prompted an exit from emerging markets.
But the decade-long sell-off has led to attractive valuations at a time when a commodity super-cycle could pave the way for outperformance, Johnstone said.
A major theme in recent years is decarbonisation. Major economies are beginning to wean themselves off fossil fuels and are looking for new ways to curb emissions, with many aiming to achieve net zero between 2030 and 2050.
By current estimates, US$56 trillion in incremental infrastructure investment is needed to meet net zero by 2050. This implies an average investment of US$1.9 trillion annually.
Central to achieving these emission targets will be transitioning our existing energy infrastructure to cleaner fuel sources, Johnstone said, adding that this places many emerging market nations in an enviable position.
That’s because the transition away from fossil fuels is likely to be metal intensive, Johnstone said. Replacing existing fuel sources with renewable electricity and manufacturing batteries to store this power will require large volumes of metals such as copper, lithium and rare earth elements.
“Now the interesting thing is where are we going to find those metals? There's a little bit in Australia and there's a little bit in Canada, but the last bulk of all the new metal discoveries we're going to need to make are going to be in Africa or in South America,” Johnstone said.
Johnstone said that demand for these metals could begin to outpace supply, creating bottlenecks and price hikes – all to the benefit of producing nations. The scarcity of these resources also places significant power into the hands of local governments to raise tax revenues, Johnstone said.
Peru and Chile, collectively producing 35% of global copper, provide a good example of this.
“Neither [Peru nor Chile] are particularly comfortable places to put more money. It costs billions of dollars to invest there,” he said.
“[But if you’re talking to] Glencore or Goldfield – who are commissioning to put US$2 billion, US$3 billion or US$4 billion into each hole in the ground in Chile - they have to sit down with President Boric and say, ‘what's my royalty rate?’, ‘what's the taxation rate?’ And the threat of expropriation is very high.”
While this does present risks to producers, Johnstone noted that these risks have been priced in.
The demand for metals is expected to support the growth of emerging markets and widen the real GDP growth differential with western markets. This helps forward price-to-earning (P/E) ratios for the sector look relatively attractive, Johnstone said.
In part, Johnstone said, this is attributable to the commitment of emerging nations to maintain tight monetary policy over the past decade. These economies have largely avoided using unconventional policies (such as quantitative easing) which western nations used to stimulate their economies following the 2008 global financial crisis. And they raised rates before developed economies – and remain ahead of the curve.
“Emerging markets have been incredibly orthodox in monetary policy because they learned their lesson and they don't want to give up the central bank credibility that they've taken 20 years to build,” Johnstone said.
“They hiked fast and they hiked early and they should be able to have the ability to cut. And what does this all mean? It just means they're incredibly cheap.”
So as developed economies struggle with soaring inflation and interest rates, past experience with inflation and monetary constraint have made emerging market economies resilient.
Johnstone said emerging markets have fallen to valuation levels not seen since 2008 while earnings continue to climb, generating attractive forward P/E ratios.
Yet despite attractive valuations, Johnstone noted that international capital flows into emerging markets are close to record lows. Since the early 1990s, Johnstone said, buying emerging markets at times when most investors are selling has proven to be a successful strategy.
“If I'd stood here in 2002 and told you to buy emerging markets, you would've thought I was mad,” he said. “Emerging markets had been through an incredibly difficult crisis. The Indonesian economy had collapsed in 1997. The rupee went from 2,000 to the US dollar to 18,000 to the US dollar in the space of six months. The Thai baht collapsed. The Korean won collapsed.
“But emerging markets did actually exactly what we told you they were going to do. Emerging market GDP grew. The emerging market growth story worked. The miracle worked. China raised 750 million people out of poverty. The Indonesian GDP has gone from US$200 billion to US$1.1 trillion. India's now a larger economy than the UK.”
With that context in mind, Johnstone said the emerging market selloff could represent a good entry point at attractive valuations for investors.
Find out how your clients can benefit from Redwheel’s emerging and frontier market investment expertise – talk to Channel Capital today.
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