Emerging markets: three things institutional investors should know

Substantive policies and a rebound in consumer activity spurs gains but investors must remain watchful

Emerging markets: three things institutional investors should know
Julie Caron, Senior Vice-president, Franklin Templeton Canada

When it comes to emerging markets (EM), independent asset manager Franklin Templeton is thinking about three things as we enter the latter half of the summer months: foreign institutional investor flows into India, earnings, and food prices. Its August ‘Emerging Markets Insights’ shows fund flows are improving for EMs.

Foreign institutional investor flows turned positive in March following a recovery in the equity market, with US$15 billion in flows year-to-date through the end of July. India’s ability to capture an increasing share of foreign institutional flows into emerging markets reflects an improvement in the market’s risk-return profile. Factors include growth-oriented policy continuity, a reduction in inflation and the twin deficits (fiscal and current account balances), and increased spending toward infrastructure projects that increase capacity and productivity.

As for earnings, consensus expectations for the MSCI Emerging Markets Index reflect a 9% decline in earnings per share during the first half of 2023. The primary countries driving the earnings weakness are Taiwan, related to the semiconductor industry, and Brazil, related to the energy sector. Investors are expecting an improvement in the outlook for semiconductor demand to lead a recovery in the second half of 2023. These expectations are providing support to the MSCI Emerging Market Index, which gained 6.3% in July 2023.

Food prices have increased in some EM sectors due to political strife and environmental phenomenon. For example, following Russia’s decision not to renew the Black Sea grain initiative with Turkey and the United Nations, the price of wheat increased 10% in July 2023. Prices of other agricultural commodities have also increased. Thai rice was up 10% and palm oil prices have increased 20%. In combination with the confirmation of the El Niño climate phenomenon in the second half of 2023, there are upside risks to emerging market inflation. Franklin Templeton says it is monitoring this for signs it is impacting margins of companies in the consumer staples sector.

Entry point for pension plans

“The opportunity in emerging markets is driven by current and expected GDP and earnings growth but also lies in reasonable valuations, historically as well as compared to developed markets, hence making it an entry point to consider for pension plans that are not currently invested in the asset class,” says Julie Caron, senior vice-president, Franklin Templeton Canada. “EM are also hard to ignore now that market leaders of some industries are from the region. Of course, growth and valuations vary across different regions within EM and selection is critical.

The asset management firm says EMs are filled with opportunities for growth. Individual countries are focused on strategies and policies to spur their respective economies. “We see upside potential as the policy picture and growth prospects improve,” says the report. “Chinese authorities have followed through with plans to stimulate domestic consumption within the automobile, property and leisure industries, among others. We believe this precedes the implementation of concrete policies to shore up the economy, which, coupled with elevated household savings, will drive the premiumization opportunity at the heart of the EM consumption story.

“We are aware that more substantive policies and a rebound in consumer activity is a prerequisite for gains in Chinese equities to persist, and we remain watchful for such developments. Outside of China, we are of the view that the semiconductor industry is starting to recover, and an inflection point in terms of memory prices could occur as early as the third quarter of 2023. This presents opportunities for Taiwan and South Korea.

“In India, we believe that there are still pockets of reasonable valuations, and there is still room for Indian equities to post further gains as earnings improve.

“We believe that a bottom-up approach is key to unearth companies set to benefit from these drivers.”

“More pension plans are moving to a dedicated allocation to EM versus investing in EM through ACWI mandates,” says Caron. “They will therefore move to specialist EM managers that have extensive experience and knowledge of the local markets, the jurisdictions, and the challenges associated with EM, and sometimes local presence going back many years.”