Fund ideas to play return to form of emerging markets

Investors who participated in last year’s great rotation – switching out of the saturated US equity market and into emerging market stocks – have had a storming year with emerging markets staging a major comeback over the past 12 months.

Both the US and developed markets more broadly have lagged emerging markets over one year; the MSCI Emerging Markets Index is up 46.3% in the year to 21 May compared to the 28% return of the MSCI USA Index and the 26.8% posted by the MSCI World Index.

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The key factors behind the rally

Stretched valuations and concerns about the concentration of tech stocks in US indices were among the catalysts prompting investors to switch out of US positions into undervalued EM companies. This was compounded by the weakening US dollar, which tends to boost foreign returns when converted back to dollars and has traditionally lowered the cost of servicing US-dollar-denominated debt, although Quilter Cheviot’s Carly Moorhouse says this is less of a consideration these days.

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Moorhouse, a senior fund analyst, said: “Historically, emerging markets tend to do well when the dollar depreciates as it becomes cheaper to service dollar-denominated debt. However, many have learnt from the past and are less heavily indebted these days.

“In fact, most major emerging markets are in better financial health than their developed peers, which are plagued by higher debts and fiscal balances. So, emerging market strength is not contingent on the dollar weakening.”

A way to play AI theme

Emerging markets are also boasting superior earnings growth forecasts, supported by demand for artificial intelligence (AI) and their growing role in manufacturing products in the supply chain, which the broader AI ecosystem – including US hyperscalers – rely on.

“Emerging markets’ deepening role in the AI supply chain have all contributed to investors’ reassessment of the region,” said Darius McDermott, managing director at FundCalibre.

He continues: “Hardware manufacturers across the region are direct beneficiaries of the colossal capex being deployed by US mega-caps. For example, Korean memory chip suppliers are pushing through price rises on the back of their market leadership, with consensus expecting 49% earnings growth across the technology hardware sub sector.”

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Moorhouse added forecasts for emerging markets generally estimate high double-digit earnings growth for this year – which would outpace those for major developed market economies – driven by the tech-heavy markets of South Korea and Taiwan and China’s technology and industrials sectors.

“The AI theme has started to feed through to Asia, particularly companies in Taiwan and South Korea,” she said. “Outside the main index constituents, there are smaller, lesser-known companies in the supply chain that have benefited too and should continue to benefit as the demand for AI increases going forward.”

Funds to play the emerging market renaissance

Dzmitry Lipski, head of funds research at interactive investor, says JPMorgan Emerging Markets Growth & Inc, managed by Austin Forey and John Citron, is positioned to benefit from the emerging market rally, with technology a core theme in the portfolio.

“The trust follows a quality growth approach, focusing on companies with strong competitive advantages and consistent earnings growth,” he said. “The portfolio is tilted towards South Korea and Taiwan and has historically maintained a preference for India over China due to concerns around China’s political and economic backdrop, while technology and financials remain key sector exposures.

“Supported by JPMorgan’s extensive analyst resources, the trust has delivered strong long-term returns and remains competitively priced relative to many actively managed emerging market peers.”

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For James Carthew, head of investment companies at QuotedData, the standout winner of the emerging market recovery has been Fidelity Emerging Markets Ord, which he says has more than doubled investors’ money over the past year. With a chunky allocation to companies in the AI ecosystem, Carthew says that it is still a trust worth considering.

“The manager (Nick Price) has the ability to short stocks and has been using that to good effect. The trust also has large positions in some of the winners of the race to develop AI, which has been a big driver of markets that are otherwise fretting about the impact of energy price hikes on inflation and consumer demand.”

Risk of buying at a peak?

However, murmurs of an AI bubble have dogged the markets for months and while the future is rosy for top-tier pioneers and AI enablers, the market shakeout of poorly capitalised companies is set to continue, which could weigh on demand for emerging market stocks.

“The emerging market rally should be sustainable as there are a lot of positive factors here,” Moorhouse said. “However, the index is becoming increasingly concentrated in three tech names – Taiwan Semiconductor Manufacturing Co Ltd ADR, Samsung Electronics Co Ltd DR and SK Hynix – which now represent over 25% of the Emerging Markets index, compared to 12.4% this time last year.

“This increases the risk that there could be a sharp sell-off should something spook markets when it comes to the AI trade. AI is not the only story in emerging markets, however, given how big a part of the index it has become, this is certainly something to be mindful of.”

Another threat to the emerging markets rally is the ongoing conflict in the Middle East, and the ensuing global oil crisis.

“The Iranian conflict has complicated the near-term picture,” McDermott said. “Higher oil prices push up inflation expectations, support the dollar and trigger risk-off moves across currencies, rates and spreads. India is currently the worst-performing market year to date, with investors betting the oil price shock will indebt its economy.”

However, McDermott caveats that over the long term emerging markets could prove to be a beneficiary of the turmoil.

“At the margins, China appears to be having some success presenting itself as the rational player against an increasingly erratic US, and has matched that rhetoric with meaningful regulatory reform,” he explained. “Meanwhile, the desire for spending on defence and clean energy infrastructure is only accelerating, and emerging market economies have the industrial depth, technical capability and resource base needed to meet this wave of demand.”

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McDermott picks Templeton Emerging Mkts Invmt Tr TEMIT – widely considered the grandfather of the sector – for co-manager Chetan Sehgal’s keen eye for recognising long-term opportunities.

“TEMIT focuses on high-quality businesses with strong balance sheets, robust cash flow generation and attractive valuations,” he said.

McDermott also notes: “Sehgal has a disciplined, ground-up approach supported by a global research platform of more than 70 analysts across 17 countries. That combination of deep local insight and structured process gives the trust a meaningful edge in identifying long-term opportunities. His focus on structural growth themes, sustainable earnings and environmental, social and governance (ESG) integration makes this a strong candidate for any investor looking for a core emerging markets holding.”

As Fairview Investing co-founder Ben Yearsley points out, ultimately emerging markets’ attractive fundamentals remain, such as lower levels of debt and a younger population, both of which will help drive longer growth that should be comfortably in excess of most developed markets.

He points out: “There are a whole variety of ways to invest especially as the lines between Asian funds and emerging market funds are so blurred.

“I like single-country funds such as Matthews China Innovators I GBP Acc, Vietnam Enterprise Ord and Ashoka India Equity Investment Ord to sit alongside a broad fund like Redwheel Next Gen Em Mkts Eq R GBP Acc.

“I’m definitely overweight emerging markets for long-term investments.”