For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Battling for market share
What do you think of when someone mentions emerging markets? High growth? Cheap valuations? Geopolitical risk? Cutting edge technology? A broad sweep of sustainable investing opportunities?
When I look at emerging markets, I see high growth opportunities married with relatively cheap valuations. I see young populations, more than 80% of the world’s total, living on three-quarters of the world’s land mass. I also see young companies battling for market share across regions whose investment spending priorities are shifting. That shift is towards delivering resilience, through diversification of suppliers, power sources, and customers, with the goal of bringing about sustainable growth.
Yet, it’s also true these markets in aggregate tend to perform better when global growth is buoyant, and worse when it is not. So, with talk of recession does the case for emerging markets still add up?
A cyclical relationship
Emerging markets’ cyclical relationship with the rest of the world can be looked at through two key lenses:
- The case for resources: Emerging markets supply large amounts of global metals and hydrocarbons, which are in greater demand as global economic growth and investment spending picks up.
- The case for people: Emerging markets have younger populations, so their contribution to economic growth in terms of labour is greater than the aging and relatively smaller populations of developed markets. But that higher economic growth potential needs more funding than an emerging market alone can supply, so these countries tend to borrow from others. This leaves emerging markets geared to a cycle of whether foreign investors are accommodating or otherwise.
Headwind, lull, or tailwind?
In 2022, a strong US dollar and the Federal Reserve’s interest rate rises were headwinds for emerging markets. A stronger dollar makes borrowing conditions harder for many emerging market governments and companies, and coupled with higher interest rates, can also discourage capital investment in ‘riskier’ markets like emerging markets.
It is unlikely 2023 will see these headwinds repeat to the same degree. As the Fed is expected soon to finish raising interest rates, the bar for the dollar to climb further in value seems high. This could prove to be a boost for emerging markets which were negatively impacted by these two correlated factors last year. What is more, emerging economies are likely to see falling inflation faster than many developed nations, in part because they could not afford the sort of Covid-19 support schemes witnessed in wealthier nations. That means scope to cut interest rates sooner and support economic growth.
Global investment spending priorities may be a good fit for emerging markets
Emerging markets may be buffeted by global trade in the short run, but a more powerful structural driver is global investment spending. That spending is returning and changing in nature to the benefit of the emerging markets bloc. For instance, Latin America is a key exporter of copper, lithium and graphite which are crucial for electrification and energy storage. Likewise, Indonesia is a large and growing exporter of nickel which is a crucial metal in battery technology. The case for resources remains strong.
What about the case for people?
Taiwan exports billions of dollars in semiconductor products and services and is likely to benefit from a step change in data demand brought about by generative artificial intelligence (AI). India remains a powerhouse in IT services. And of course, China’s lead in the manufacturing chains of solar modules, wind turbines, electrolysers and battery recycling may yet prove too great to be overcome. While tensions between the US and China over trade continue the resulting supply chain shift away from China may benefit other emerging economies.
Mexico has received help from ‘near-shoring’ to the US, and foreign direct investment there is at decade highs. Other beneficiaries of shifting supply chains include India, Malaysia, Vietnam, and countries across the European periphery. Where China is losing, other emerging market countries are gaining. And a dollar taken out of a factory in China and reinvested in these countries carries more weight given the smaller relative size of those nations’ economies.
Putting the customer first – a sustainable competitive advantage
One feature of a business we prioritise when looking for investments is customer-centricity. This is a broad area that I would define as working as closely as possible with customers to establish a mutual reliance.
Companies refer to this in different ways, be it ‘small batch manufacturing’ or ‘high customisation’ or ‘high mix, low volume.’ But the essence is the same, that market incumbents, who are often branded firms suffering from high cost inflation, need to mitigate those pressures through standardisation of product.
Emerging market companies, by contrast, are not only integrating themselves as manufacturers of products of increasing complexity as developed market firms look to migrate to service relationships but are also happily embracing bespoke projects rather than rejecting them.
Contract manufacturing – a question of trust
Outsourcing to a third party where processes are highly capital intensive can be enormously efficient, such as with semiconductor manufacturing and the so-called ‘pure foundry’ model established by Taiwan Semiconductor Manufacturing Company (TSMC). The rationale behind this being that it is better to have a single billion-dollar factory run at full capacity by a single trusted third party, than have several billion-dollar factories operating in-house at lower levels of utilisation. There are pitfalls however for the developed world: give up too much control, as we have seen with solar cells, and you may never regain it.
Customer centricity case study: Voltronic
Another Taiwanese firm has successfully carved its niche in the design and manufacture of uninterrupted power supply (UPS) devices, and inverters. Inverters manage the flow of current, while UPS devices maintain the consistency. In a world requiring higher electrification, more dispersed and intermittent sources of electrical power, and the charging of electric vehicle batteries at home or on the street, Voltronic’s product portfolio is attractively positioned. These aren’t simply for electric vehicle drivers in the western world; some of Voltronic’s biggest customers last year were found in South Africa where power cuts continue to plague households and businesses, and in Pakistan in the wake of devastating floods in 2022.
However, you’ll never see Voltronic’s name on these products. Buy a UPS device from market leader Schneider Electric, and there’s a high chance it was made by Voltronic. Developed market incumbents in these industries are changing their business models: from manufacture of product to more consulting work and passing over product portfolios to companies like Voltronic. This isn’t delegation, it’s acknowledgement of specialist expertise and trust: Voltronic manufacture not only for Schneider, but most of the top global vendors of UPS products from the United States to Japan. That takes mutual trust and expertise, not just price, and Voltronic’s returns on invested capital – 46% in 2022 – reflect that.
The bigger picture for emerging markets
Regional equity performance vs relative GDP growth
Source: IMF Forecasts data from 1980 to 2027 (forecast).
Globalisation has peaked. Reconfiguring the world economy for resilience will doubtless bring challenges and require large scale investment, but it will also offer huge opportunities to a broad range of emerging markets. Long term investors naturally expect GDP growth to be higher in emerging economies than in developed countries. This ‘growth differential,’ which acted for years as a strong positive catalyst for foreign flows and equity returns and a pre-requisite for emerging markets out-performing developed market equities, is once again on the rise according to IMF forecasts. Exciting times lie ahead.