Emerging markets: Opportunities for growth and retirement plan portfolios?
April 9, 2018
We believe the long-term case for emerging market equities is positive, especially for investors who seek to diversify their equity allocations. From our perspective as research-based investors, we think focusing on company-level analysis is the best way to approach the asset class. But first, let’s consider a few points about the current macro environment.
Favorable growth dynamics
Across emerging economies, fundamentals are improving. In a deliberate, organized shift, countries are pursuing responsible monetary and fiscal policies. This is exemplified by stimulative measures in countries that include China, Indonesia, South Africa, India, and Malaysia. Policy specifics vary by country, and we do not imply that stimulative policy can lift all emerging countries at once. But on the whole, we think positive developments are under way.
An expanding consumer class
A growing middle class within a number of emerging economies is giving rise to a profoundly expanding consumer base. Few countries exemplify this transformation as well as China. These are some of the conditions that are facilitating this sea change1:
- Hundreds of millions of Chinese are entering the middle class, creating, for the first time in history, a substantial group between the elite and the masses.
- The labor market is tightening. In each of the last 10 years, more than 10 million jobs have been added to the Chinese economy.
- As a share of the Chinese population, urban dwellers have tripled since 1980, and they now represent more than 50% of the total population. This has positive connotations for the country’s consumerism, because urban households tend to earn higher incomes and spend more than their rural counterparts.
China’s evolving economy does not capture the entire story, however. It merely illustrates the same growth dynamics taking root in other emerging economies. Within Asia alone, evidence of an expanding consumer class can be seen in countries such as Indonesia, where an estimated 90 million people will join the middle class by 2030, and in Malaysia, where the consumer class is starting to make a meaningful contribution to economic growth.
The table below highlights additional factors that are contributing to the transformation that is under way.
Four catalysts for growth in emerging markets
|Widespread increase in consumption
- Annual consumption across emerging markets will rise from $US12 trillion in 2010 to $US30 trillion by 2025. During the same period, the share of world consumption will increase from 32% to 47%.
- As millions move into the middle class, rising incomes are driving increased spending on discretionary items such as cars, clothing, and appliances.
||The stabilization and rebound of commodity prices in 2016 was a precursor to a cyclical uptick in global economic activity that is expected to drive demand for raw materials as we continue into the coming quarters.
||Emerging economies are expected to grow at a pace of 4.7% for calendar year 2017, rising from a rate of 4.1% in 2016.
|Recent softening of the US dollar
||A weaker US currency makes it easier for developing countries to pay back dollar-denominated debt.
Data: Bank of America Merrill Lynch (economic growth expectations); McKinsey (consumption).
Beyond macro conditions: Company-level analysis
Within the context of these positive macro conditions, several company-specific examples of investment ideas show strong potential for growth.
One example comes out of South America, a continent that is grinding its way through a host of fragile situations. Corruption, unstable public finances, pensions in need of reform — these headwinds have been part of the narrative, without question. Nevertheless, stories of genuine entrepreneurship can be found at the company level. We are seeing evidence of companies that are managed effectively and competing vigorously. These firms are generating decent cash flows and building sustainable business models, with smart allocations of capital.
For some of these companies, the rise of Internet technology has paved a route to success, as shown by firms such as Mercado Libre, an Argentine operator of an online marketplace. We believe the company is run by a capable management team, and its results have shown as much: Sales volume is growing at a rate that is somewhere between two and three times that of Amazon. The company’s competitiveness can be illustrated with other metrics as well, including a so-called take rate of 7.5%2.
In Brazil, to cite another example, the same dichotomy holds true: The country’s macro conditions are not without sore spots, but company-level research can reveal compelling opportunities. Here, a traditional retailer with a large footprint (approximately 800 stores) is operating an online marketplace that is getting meaningful traction. The company’s performance is strong enough that it has essentially put a virtuous cycle in motion, by which it is able to arrange attractive financing terms, fund new initiatives, and do so while keeping its balance sheet in good order.
Mexico also is nursing its share of structural and political problems yet provides a home for companies determined to compete. There appears to be room for growth across several industries, and wireless communications is one worth studying. Operators of cell towers, for instance, appear poised to expand, particularly in light of the penetration rate for mobile phone usage in Mexico — it is relatively low, and we think it will grow.
Stock selection is where performance originates
While macro concerns are always part of the emerging market landscape, we believe company-level research can reveal compelling opportunities. We think it makes sense to focus on companies that are early to market and have the potential to grow. In other words, we think portfolio returns can benefit from identifying early-stage growth companies that have the potential to add scale. With the right people, processes, and entrepreneurial drive, good companies in emerging markets can earn their way toward becoming great companies, rewarding investors along the way.
Emerging markets: A considered approach for retirement portfolios
Diversification is one of the fundamental steps that long-term investors ought to embrace, and retirement plan participants are no exception. Historical evidence, academic models, and conventional wisdom coalesce around the practice of diversification and its propensity to deliver positive outcomes over the long run.
Despite the well-known benefits of diversification, many retirement plans offer simplified investment options that are limited to certain asset classes. True diversification, however, comprises a wide array of asset classes, including those that don’t always receive star billing; emerging market equities make up one such asset type.
First things first: Plan demographics, investment menus
What should sponsors keep in mind when considering emerging markets equities for their retirement plans? As a starting point, it makes sense to think carefully about plan demographics as well as the plan’s current investment offerings, aiming to answer the following questions:
- Does the plan have a high participation rate, and are participants engaged?
- Are participants savvy about investing?
- Can participants handle downside volatility?
- Do participants trade frequently, or do they generally have a buy-and-hold mentality?
- Is the plan’s investment menu fairly simple, or does it offer many options?
- Is education needed to make sure emerging markets equities would be used properly?
- Do any of the plan’s investment options — such as an international equity fund — already have exposure to emerging markets?
- Are custom target date solutions used in the plan, and if so, do emerging markets equities have a place within them?
No longer a niche asset class, but education still key
As the universe of emerging markets equities continues to expand, it is shedding its status as a niche asset class. Investors increasingly understand that it is not a carbon copy of other, more prominent international markets. Nonetheless, many investors view emerging markets with caution, harboring doubts about their risk-return characteristics. Because of this trepidation, it makes sense for plan sponsors to approach them carefully, providing plan participants with plain-spoken explanations of how they can work within a well-diversified retirement portfolio.
An effective education effort could help investors understand basic concepts such as the following:
- An allocation to emerging markets can help put diversification theory into practice; in other words, by employing an additional layer of diversification – especially in international markets – investors can potentially increase portfolio returns over time.
- As globalization continues to alter the economic landscape, retirement investors can use emerging markets to participate in an every-changing global economy.
- A long-term investment horizon is a natural fit for emerging markets, which can experience occasional bouts of short-term volatility.
Ultimately, plan participants should be empowered to make wise allocation decisions based on their investment horizons and attitudes toward risk. With the right approach – and a focus on investor suitability – emerging markets can make valuable additions to retirement portfolios, providing diversification benefits through access to wide-ranging segments of the global economy.
As of Dec. 31, 2017, shares of Mercado Libre constituted a 2.92% position weight within the Emerging Markets Opportunities portfolio managed by the investment team. The company is mentioned for informational purposes only and the portfolio position is subject to change at any time. Discussion of the company should not be construed as a recommendation to buy, sell, or hold any security.
1Based on research conducted by: McKinsey (growth of middle class); Federal Reserve Bank of Kansas City (labor market); and China National Bureau of Statistics (urban population).
2This measures the company’s revenue and is calculated as a percentage of the total value of goods sold on its platform.
The views expressed represent the Manager's assessment of the market environment as of April 2018, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.
Diversification may not protect against market risk.
International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Emerging market equities entail their own unique risks. Such risks can include fluctuations in currency values, varying accounting principles, and periods of economic or political instability. Emerging market equities may also experience episodes of increased volatility and lower trading volumes, particularly when compared against developed-market equities.
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