This episode’s focus is on the current investment climate for emerging markets and why now might be a good time to reconsider the asset class.

 

Announcer: Welcome to the Allspring Global Investments podcast where we explore what’s happening in the markets and discuss our outlook for the ever-changing investment landscape. Thought leaders provide their views on the latest global trends in sustainability, technology, emerging markets, and more. Join us as we take you down the road of investing elevated.

Chris Guerrieri: I’m Chris Guerrieri, head of integrated distribution for Allspring Global Investments, and you’re listening to On the Trading Desk®.

Joining me today are Derrick Irwin and Alison Shimada, representing Allspring’s Intrinsic Emerging Markets Equity and Total Emerging Markets Equity teams. We will be discussing the current investment climate for emerging markets and discussing why now might be a good time to reconsider the asset class. Thanks for being here, Derek and Alison.

Derrick Irwin: Good to see you.

Alison Shimada: Thank you.

Chris: Investors who are bold enough to click on the play button, we have to understand that they are probably approaching this podcast with a degree of pessimism and wondering why would I even consider investing in emerging markets right now?

Alison: I think the reason to consider emerging markets at this point is because there is a sufficient degree of pessimism in the markets. We will see better times ahead. And I think it’s good to consider emerging markets when others are not.

Derrick: And I really feel like the conditions are developing for what could be a very strong run of performance for emerging markets, certainly, like we’ve seen in the past.

Chris: Okay. Many investors believe that they get their emerging markets exposure through a diversified international mandate. How do you feel about investors who choose to get their emerging markets exposure through a diversified international approach rather than a focused, emerging markets investment approach?

Derrick: Sure. First of all, it dramatically decreases the pool of available assets you can invest in. The tail on a global portfolio of emerging market assets is quite small and doesn’t necessarily represent the best that emerging markets has to offer. Very good companies, for sure. But there are other opportunities in emerging markets that a dedicated manager with significant experience and a strong team can uncover.

Alison: I think that dedicated EM (emerging markets) managers just go deeper. Of course, we all know the super large companies in emerging markets, but there are other very interesting companies with unique technology or services that are very relevant to those local economies. And you’re just not going to really access that necessarily in a global fund.

Chris: Why don’t we start with a question that’s on the minds of many investors and pertains to the strength of the U.S. dollar? What impact has the strong U.S. dollar had on global investing in general? And Derrick, maybe you can take this question first.

Derrick: Sure. This has been a challenge for emerging markets now for almost a decade, but it’s really coming to a head through 2022 where we’ve seen the dollar up versus its trading partners well over 7%. So, we’re seeing a very strong dollar. And that has significant impacts for emerging market investors.

First of all, a strong dollar tends to drain liquidity out of emerging markets. And second of all, given that a lot of debt in emerging markets is denominated in U.S. dollar, it can create strain on emerging market businesses. Although to be fair, the amount of U.S. dollar debt now is significantly lower than it used to be, but still a strain.

On the flip side, it does help emerging market exporters. It makes their goods that they’re exporting to the U.S. cheaper. But often, that’s not enough to offset the headwinds from a strong U.S. dollar. It has indeed been very strong.

As I said, it’s been about a 10-year bull market in the dollar versus not just emerging markets, but its trading partners. What’s important to me is that the dollar from our perspective does seem stretched. So, we look at that from a number of different ways.

But if we look at the trade-weighted dollar, which weights the dollar versus its major trading partners around the world, it’s approaching and, in fact, in July, exceeded its 2002 peak, which was just before nearly a 10-year slide in the dollar’s value versus both emerging and developed currencies.

So, we think the dollar is reasonably expensive. Other measures certainly would agree with us. Goldman Sachs has a very widely used measure of dollar valuation called the GSDEER. And that suggests the dollar’s about 20% overvalued versus its major trading partners, which, again, is a similar level to the last major peak in the dollar in 2002. So, the dollar does appear very strong, but it certainly has been up until now quite a headwind for emerging market equities.

Chris: Thanks, Derrick. Alison, do you have anything to add in addition to the comments that Derrick just shared?

Alison: I would say looking forward a little bit here, I think there’s an opportunity with the strength going back to the levels of 2002 that you see somewhat of a slight reversal here in the dollar because though you have rates going up, you have rates going up in other parts of the world, as well. And I think there’s sort of a relative value argument and you see an appropriate response by equities and bonds in other countries, particularly in emerging markets, has already happened.

So, I think that that combined with the idea that many of the emerging markets countries do benefit from a weaker currency since they are exporters, in the case of South Korea or China. So, we do see some potential for possibility of money shifting over to emerging markets in a kind of tactical or definitely a shorter term opportunity, but maybe even longer term to reverse that trend.

Chris: Why don’t we move to the next, what I’ll call, very big topic that’s on the minds of investors. And that has to pertain to China. We’re hearing a lot of questions about China. How will the regulatory crackdowns and zero-COVID policy impact the country’s growth outside investment into Chinese companies and your portfolios? And in the interest of fairness, Alison, why don’t you start with the first response?

Alison: Okay, terrific. Well, I think that the overriding thought that comes to mind is the zero-COVID policy because the regulatory crackdowns have actually been going on for a few years here with regards to corruption, with regards to data privacy, etc. So, I think the COVID policies and the fact that the government has been unwilling to change that policy really has a large impact on economic growth in China. And in the second quarter, of course, we saw that with a GDP growth of only 0.4% versus 4% to 4.8% in the prior two quarters. So, I think that you probably have seen a peak pessimism certainly in Q2.

And things could change a bit, of course. There are recent events. There’s always news events that occur and can throw the market off a little bit, but I would caution against looking to short term and thinking a little bit more about the overall possibilities. I am not assuming and I don’t think our team is assuming massive investment in China from the outside.

What is happening now is the government is turning much more towards growing its own companies now and focusing on the resources within the country to develop high tech sectors, IoT (internet of things), data, related services. So, a lot of the expertise will come from companies within China and for the Chinese market.

So, I think that the zero-COVID policy isn’t going to go away necessarily, but there will be some relaxation over time as they see continued conditions hopefully improve. And there will be more mobility. And that’s really the key factor, I think, for better economic growth.

Chris: Thanks, Alison. Derrick, any thoughts on China?

Derrick: I think Alison is exactly correct on some of the headwinds in the Chinese economy. I would say, though, that what we’ve seen is really as a result of regulatory headwinds, as Alison mentioned, and of course, zero-COVID, as well as some geopolitical concerns, a significant derating of many Chinese companies that really is not in line with their fundamentals.

We really think in terms of finding good companies first and then trying to understand what the long-term value of those companies are. And what we’re seeing now is that those two things aren’t aligning particularly closely.

We have very good companies with very strong long-term fundamental opportunities that are trading at valuations that are, quite frankly, depressed or distressed. And we think that that can create an opportunity for long-term investors. I do agree with Alison in the near term. There are certainly some headwinds, but the trajectory is probably more positive than it has been. And we think that as we do see an improvement in economic growth over the next year or so, we may well see improvements in some of the share prices of these companies.

Chris: Fantastic. Thanks for your perspectives. With the time we have left, perhaps you could leave our listeners with a few final thoughts to consider while allocating assets to emerging markets. And Derrick, why don’t we start with you?

Derrick: Sure. I think when we think about emerging markets, as I said, the relatively weak returns versus the major equity indices around the world over the last few years cast emerging markets in an unnecessarily dark light.

If we look over a longer period of time, not only have emerging markets performed very well against nearly all benchmarks, but it provided significant diversification benefits for investors. So as part of a long-term asset allocation, emerging markets really are quite critical.

Second, with regard to soft returns over the last few years, there are a lot of indicators that we look at that do appear stretched that could suggest stronger relative returns over the next few years. We talked about currency, for sure. Relative growth rates between EM and DM (developed markets) seem to be moving in favor of EM.

And we think that those two very broad drivers combined with very strong companies trading at discounts to their long-term intrinsic value really are a great opportunity for long-term patient capital.

Chris: And Alison, how about you? Any final thoughts to leave our listeners with?

Alison: Yeah, I think that the last 5 to 10 years, you’ve seen a tremendous increase in popularity of passive investment vehicles, such as ETFs (exchange-traded funds). And I think that it’s been about 5 years since people even really had to differentiate between funds or strategies that, that have better track records and those who don’t. Because over the 2016 to 2020 period, there was a period of time where all pretty much growth stocks were doing extremely well. And you could just follow along with that through an ETF and you’d be okay.

But I think that this is a little bit of a different world now in the sense that active management and decision making and judgment really makes a difference. And the experience is very critical now because you have to often go against what the consensus view is in order to maintain outperformance. And you can see by the difficulty that funds are having in the marketplace that this is a difficult market. And so, I think that it’s important to consider how you invest in emerging markets, as well.

The fact that allocating is a really good idea, especially in times like this when it is difficult, but it’s the best time. Absolutely the best time to go in to an asset class when things look a little bit difficult because at some point, you will be actually looking at markets that are performing much better, as Derrick mentioned. And so, I think that active management needs to be part of the equation, as well.

Chris: Derrick and Allison, thank you for being with us today and for sharing your insights.

Alison: Thank you very much.

Derrick: Thanks for having us.

Chris: That wraps up this episode of On the Trading Desk. If you’d like to read more market insights and investment perspectives from Allspring Global Investments, you can find them at our firm’s website, allspringglobal.com.

To stay connected to On the Trading Desk and listen to past and future episodes of the program, you can subscribe to the podcast on Apple Podcasts, Spotify, or wherever you get your podcasts. Until next time, I’m Chris Guerrieri. Thanks for listening.

 

Disclosure: Diversification does not ensure or guarantee better performance and cannot eliminate the risk of investment losses. Asset allocation does not ensure or guarantee better performance and cannot eliminate the risk of investment losses.

 

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