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Are emerging markets attractive?

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Five reasons why emerging markets are attractive. The analysis by Tim Love, Investment Director responsible for emerging market equity strategies at GAM Investments.

The first quarter of 2022 was even more intense than the previous year, with two major geopolitical events, namely the Russian invasion of Ukraine and, immediately after, the indiscriminate sell-off by Chinese ADR investors. Nonetheless, we believe there are numerous reasons to consider emerging market equities.

INTERESTING PROFIT FORECASTS

Despite the higher beta of emerging market equities since the beginning of the year, we believe robust GDP and valuations, as well as the resilience of earnings per share, should favor this asset class. For example, as of April 21, 2022, the forward PE of the S&P 500 was 19, compared to a much lower 7.5 on the Hang Seng China Enterprises Index or 9.8 on the MSCI EM Index. These data clearly show that this investment category has been underweight, overlooked and undervalued by investors.

A DIFFERENT COMPOSITION FOR THE EMERGING MARKETS INDEX

The MSCI EM index has changed a lot in recent years. It once comprised non-investment grade countries, while today it is comprised of a group of investment grade, liquid and recovering markets, with lower credit risk, capable of appealing to those who invest in value, growth and yield.

As of April 27, 2022, South Korea, Taiwan, India and China accounted for around 69% of the index, followed by 20% from Saudi Arabia, South Africa, Brazil and Mexico. If we add the Gulf countries (Qatar and Bahrain), Thailand and the Philippines, we get almost the entire index. In other words, Turkey, Russia, Venezuela, Peru, Colombia, Argentina, Romania, Hungary, the Baltic countries, Pakistan, Vietnam and African countries (excluding South Africa), which are considered most at risk, represent less than 1% of the MSCI EM Equity index.

INTERESTING RISK AND RETURN PROFILE COMPARED TO THE DEVELOPED MARKETS

Thanks to the robust valuations and the diverse composition of the index, the risk and reward profile of emerging equity markets appears, in our view, attractive compared to developed markets.

Perhaps contrary to expectations, emerging market equities outperformed most advanced markets in the first quarter of the year, despite the upheavals to the asset class following the Russian invasion of Ukraine and the indiscriminate sell-off of ADRs. Chinese for fear of their exclusion from the stock market lists.

Over the long term, we believe that emerging markets not only have lower downside potential than developed markets, but also higher upside potential, having been devalued heavily over the past 15 years. Indeed, emerging market valuations are now close to 2004 levels, after which we have seen a period of robust outperformance versus developed markets.

IMPROVING ESG CREDENTIALS

Given that emerging countries account for more than half of world GDP and almost 70% of the continental mass, environmental, social and governance (ESG) factors are extremely important. In key emerging markets, significant progress has been made in ESG, for example in China, South Korea, Taiwan and India, and this will continue. As a result, we believe that emerging markets can offer benefits to investors who want to contribute to this change and to improve ratings.

CHINA: THE WAY TO THE RISE

We cannot talk about emerging markets without acknowledging the importance of China which, as of April 27, 2022, represents 27.6% of the MSCI EM index.

Fearing the country’s passive involvement in the conflict between Russia and Ukraine, the Chinese index hit an all-time low in mid-March 2022. This was followed, however, by the largest daily rebound ever recorded by Chinese equities. The speech by Chinese Vice Premier Liu He in fact addressed some worrying issues, such as the stability of the real estate market and the issue of US ADRs, but also shed light on the regulation of the technology sector. If the statements are followed by concrete action, we believe that the current level of the markets may be the absolute minimum or at least relative. We see exciting opportunities in areas aligned with introduced policies, including technology software, the electric vehicle production chain and renewable energy sources, such as solar energy.

There is no doubt that the past 15 years have not been easy for investors in emerging equity markets; therefore, this asset class has gone off the radar. Despite recent volatility, we believe there is reason to be optimistic, emerging market equities present attractive opportunities for active investors. They have demonstrated this since the beginning of the year with respect to developed markets. If we are right, we believe that we will also see outperformance in absolute terms.

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