While institutional investors are no strangers to established markets such as Europe and the U.S., the world’s emerging and frontier markets can provide diversification and opportunities for lucrative returns.
Not surprisingly, events such as the coronavirus pandemic and a shifting geopolitical landscape are influencing these decisions in 2022 and beyond.
In recent months, Russia’s invasion of Ukraine is impacting the inflows and outflows of funds in emerging and global markets, says Angela Lin-Reeve, senior portfolio manager of pension investments at the Royal Bank of Canada. With oil prices climbing higher, oil exporters such as Nigeria and Middle Eastern markets like Saudi Arabia and the United Arab Emirates are seeing increasing capital inflows. Similarly, she notes, inflation and supply chain issues are increasing the focus on commodities producers such as Brazil and South Africa.
“We’ve seen outflows from Eastern Europe and Egypt — these are countries that rely heavily on imports from Russia and Ukraine. We’ve seen that in the form of food inflation; that region exports a lot of grain and countries like Egypt and Hungary are very reliant on those exports.”
Middle Eastern markets rising
In addition to the impact of oil prices, Middle Eastern markets like Saudi Arabia are attracting institutional investors through economic reforms, says Dominic Bokor-Ingram, senior portfolio manager of frontier markets at Fiera Capital Corp.
“Real reforms in energy producing countries are rare. Generally, there are reforms when the oil price is low and, when it goes back up, they decide not to reform any more. What’s happening in the Middle East is they started reforms in 2015 when oil prices were low. The actual pace of acceleration of reforms has picked up as oil prices increased, which indicates they’re very serious about it. They’ve got the money now to do it and build non-oil economies.”
For investors, the most exciting parts of Saudi Arabia’s economy are those that didn’t exist seven years ago, he says, noting Fiera holds investments in consumer credit, electronics retailers, gyms and technology consultancies in the country. “There’s massive change in the culture in Saudi Arabia that’s brought about new business opportunities. Three years ago, there wasn’t a single cinema; today, there’s 50. It’s very likely in the near future, they’ll allow alcohol and gambling — a Monaco in the Middle East. . . . You’ve got a perfect storm of high energy prices and the windfall is being used to fund the growth of the non-oil economy. The reason this has all happened is they’ve realized, at some point, oil runs out.”
The region has grown from zero per cent of the emerging market index in 2014 — the year Qatar and the UAE were upgraded to emerging market status, followed by Saudi Arabia in 2017 — to eight per cent of the index in 2022, he says, while the average active fund manager has just 1.3 per cent exposure to these markets.
“That’s massively underweight in a region that’s suddenly becoming quite significant. . . . Given the pipeline of privatization and [initial public offerings], I think it’s going to be more than 10 per cent by the end of 2023. If oil stays where it is, it’ll be even bigger. There are only four emerging markets bigger than that — China, India, Korea and Taiwan. China is going to move to stand-alone at some point and Korea is in the process of being upgraded to a developed market, as will Taiwan.”
However, the Middle East poses some challenges to institutional investors, says Kathryn Langridge, Manulife Investment Management Ltd.’s senior managing director and senior portfolio manager. “It’s still a challenging place to find the types of companies we focus on, which are best-in-class companies that deliver compounding quality growth and superior returns on investment capital over the long term. The Middle East markets still tend to be dominated by state-driven enterprises, so you’re getting volatility tied to oil and the volatility that comes from high levels of state direction of capital allocations.”
The growth of South Asia
While the pandemic led to a global semiconductor shortage, their producers have long been rethinking supply chains, says Jin Zhang, a portfolio manager at Vontobel Asset Management, noting these companies reconsidered Russian sources of materials like neon and palladium following the country’s 2014 invasion of Crimea.
“All of these geopolitical tensions are making supply chain management more difficult. When we talk to our companies, what we’re hearing is there’s a change in attitude. They’re going from globalization and a just-in-time inventory system and running their supply chains very lean and efficient to running surpluses, having redundancies and multiple sources.”
As a result, duplicate supply chains have been growing in South Asian nations such as Indonesia, Malaysia, the Philippines and Thailand, leading to increased investor focus on these markets. “Supply chains move very slowly — this change started before the pandemic, which actually delayed [this change]. Companies aren’t packing up and moving from China, but they’re expanding to these other markets.”
In addition to semiconductors, Zhang says Vontobel’s institutional investor clients are invested in Indonesia’s two largest banks, as well as Thailand’s Siam Commercial Bank and airport management company Airports of Thailand, noting the two markets emerged strongly from the pandemic. He notes there’s also an increasing investor focus on Vietnam, particularly in consumer brands, the financial sector and real estate.
“We’re looking for high-quality companies that have proven themselves to be strong. The vast majority of companies we look at are quite profitable and we spend a lot of time assessing sustainability, including [environmental, social and governance factors]. We want to make sure it’s a reasonably stable environment and the currency isn’t about to collapse. On that front, Vietnam looks very strong.”
Similar to the Middle East, Vietnam poses the challenge of a complex relationship between government and private enterprise. However, Zhang notes this arrangement can also provide opportunities. “Some companies are linked to the government and it can be a positive; for example, companies with close connections to state-owned banks. There’s a lot of linkages between state-owned entities, but we look at them very closely.”
Fixed income opportunities
Tom Nicol, vice-president and director of emerging market strategy at AllianceBernstein, says while the investment management firm isn’t currently running a huge amount of risk in its portfolios — due to factors such as Russia’s invasion of Ukraine and China’s zero-tolerance approach to the coronavirus and the potential impact on growth — there are fixed income opportunities in commodity-exporting countries in Latin America and sub-Saharan Africa.
“You can’t buy every country and selectivity is extremely important. Importers of oil and food are especially vulnerable at the moment — they’re contending with inflation and government subsidies and investors have to be careful there.”
While he says North American institutional investors have historically sought a 50/50 blend between hard and local currency sovereign, hard currency corporate debt has been incorporated into that blend over the last few years.
“If you look back over long periods of time, you get much more attractive risk-adjusted returns in the hard currency space than the local. Within sovereigns and corporates, it’s interesting: in corporates, if you’re just looking at risk-adjusted returns, [emerging market] hard currency corporates have the best risk-adjusted returns. But we prefer to invest in the sovereign space. There’s more liquidity and the absolute level of return you can get is higher than corporate.”
Lin-Reeve has seen an increased focus on the sovereign debt of countries that are closely tied to the U.S. economy, such as Chile and Mexico, which have progressed in tightening monetary policy to combat inflation while offering an attractive yield. “We’ve seen money flow into those economies that seem to be stronger coming out of the pandemic.”
The importance of diversification
As an open defined benefit pension plan, the multi-employer LiUNA Pension Fund of Central and Eastern Canada is taking a long-term approach to its investments with a focus on diversification, says Carmen Staltari, senior director of investments at WTW and the LiUNUA plan’s investment consultant.
“Most DB plans in Canada are closed and in the windup phase, looking to do an annuity purchase or let it wind down itself. We need to be forward thinking and looking for new ideas because the plan needs to support its obligation to members. What’s key for this plan is diversification, particularly in this environment where there’s volatility in the equity and bond markets. The traditional areas where pension plans have invested their money are turning out to be very difficult places to be at the moment.”
To that end, the LiUNA halved its traditional bond allocation in 2018 and expanded to global private debt and alternative credit. While the plan’s focus in these sectors is mainly tied to the European and U.S. markets, Staltari says the plan’s investment managers are also eyeing opportunities in Africa.
“We’ve always advised the plan to have diversification in their portfolio because they’re invested for the long term. We’re going to go through cycles and the equity markets will always experience volatility. In the bond market, we were just waiting for the time when interest rates were going to rise and that’s finally come to bear.
“Certainly, within fixed income, part of that private debt and alternative credit space would be in emerging markets. Today, there’s elevated risk, but over the past couple of years, it’s been a piece of the broader portfolio. We’re not looking to expand it specifically, but it’s part of the overall allocation and provides diversification.”
What the future holds
While the pandemic’s impact on investments may be receding in much of the world, Langridge says it’s very much alive and well in China, where the economic powerhouse’s zero-tolerance approach to the coronavirus has led to multiple cities in lockdown this year.
Although these restrictions are beginning to ease, she says the economic impact will continue for months, prompting some investors to question their allocations in China, though she notes this isn’t the right approach. “That’s a much bigger decision in the long term to not invest in China, because it represents a sixth of global GDP and a third of global growth in the last decade. To cut China out of a global investment strategy would be hard to justify, in terms of both risk and growth diversification.”
The situation also presents an opportunity, says Lin-Reeve. “Valuations are very compelling now in some sectors of the Chinese stock market. We see more value investors entering markets at valuations that are very compelling.”
In addition, as the geopolitical landscape continues to shift, Staltari notes diversification will become increasingly important. “The typical balanced portfolio has done well over the past 10 years, but year to date, those portfolios have struggled. LiUNA was well-positioned ahead of the coronavirus pandemic, when equity markets fell in March 2020. At that time, we looked at the portfolio and aside from the equity portfolio, everything else was pretty much intact.
“With volatility, higher interest rates and rising inflation, those asset classes perform well in that environment. We’re being prudent and constantly re-evaluating, but we really just validated the strategy and decided to stay the course.
“This is long-term work. It is work that is necessary and needed, but . . . if it was just one thing that you could do, everyone would do it.”
Blake Wolfe is the managing editor of Benefits Canada.