Emerging market economies showing promise - Andrew Ness

Global economies have faced a number of challenges in recent months, leading to depressed stock market returns. The Russia-Ukraine war continues to have ripple effects and although most countries have gone back to business as usual following the peak of the Covid-19 pandemic, the virus is probably not going to fully disappear. China’s “Zero-Covid” policy has been weighing on economic activity there. Other well-known market challenges include rising inflation and interest rates as well as the surging US dollar.

Despite these headwinds, emerging economies continue to prove their resilience. We believe it is now a compelling time to consider emerging market equities.

For example, as inflation began to accelerate post-pandemic, emerging economies were preemptive in tightening interest rates. While the United Kingdom, the eurozone and the United States are still trying to catch up with rising inflation, many emerging economies have largely completed their tightening cycles. Brazil started tightening in March 2021 and has made 12 consecutive rate hikes. Inflation has been decelerating there in recent months, leading the central bank to pause its hiking cycle in September. The US Federal Reserve, meanwhile, did not start raising rates until March of 2022.

Emerging market equity valuations are also attractive, trading at near historic discounts versus the developed world. In our analysis, the relative profitability between these two asset classes does not warrant the current 45% discount on a price-to-book basis.2 Relative to its own 15- to 20-year history, emerging markets as an asset class is one of the few that looks cheap. The MSCI Emerging Markets Index is trading at about 10 times forward earnings, compared to around 18 times for the US S&P 500 Index (S&P 500).3

During challenging economic times we are likely to see more early-stage companies need access to further funding

Additionally, emerging market companies have been recently increasing dividends, using cash flows to distribute dividends to shareholders rather than deploying capital given uncertain growth outlooks. Company managements have also been seeing value in their equities, resulting in increased buyback activity. While the persistence of high dividend levels is unlikely to remain at the current 4%, there has been a sea change in how emerging market companies think about capital optimization and balance sheet management.4 Over the past 20 years, approximately 2.5% of annualized total returns of 9% have come from dividends.5 Thus, there has been dividend support to the asset class, which many investors may not realize.

Lastly, emerging markets offer investors opportunities in high quality and high growth companies. They are home to some of the most innovative, technology-oriented companies globally—companies that are building the digital architecture around us. These include hardware and software suppliers as well as semiconductor manufacturers. Some are even responsible for the transition to decarbonization. Many emerging market companies are global leaders in the production of electric vehicles and electric batteries, and in renewable energy such as in solar manufacturing.

Over the long term, we are increasingly optimistic about emerging market economies. Despite the current environment of slowing growth, rising inflation and geopolitical issues globally, we have confidence in the emerging markets asset class and will continue to seek high-quality business with solid balance sheets, competitive advantages and attractive valuations.

Andrew Ness, Portfolio Manager, Templeton Emerging Markets Investment Trust (TEMIT)