Trends in Emerging Markets, From ETFs to Trump

realized-profitThere has been a dramatic shift in the composition of emerging markets in the last decade as Latin America’s role as diminished and emerging Asia has grown.

That’s according to Alex Duffy, portfolio manager at Fidelity International who was speaking today in Toronto. He explained that Latin America, which used to represent about 50% of emerging markets equities has dropped to 30% at the same time as Asia has become 70% of the universe.

No matter what economic environment we’re in, however, one constant has remained – currency is still the biggest impediment to investing in emerging markets, even today as exchange rates begin to stabilize. That means companies operating in this region need to spend wisely and keep both assets and debt balanced. “Because if there is a currency drawdown, you will have a huge loss,” he explains, adding that “The best companies in the universe are those that are able to manage their capital well so they can withstand the pressures of currency devaluation.”

Duffy also addressed concerns over systemic risk in China due to the amount of debt buildup in the Chinese economy. In dealing with overcapacity in the economy, however, the government has been working to keep capital close to home – and while debt might have been misallocated, China has moved to “force a shift of U.S. foreign currency debt to local currency debt.” A critical move that will bolster China’s ability to hold capital in the country.

If China loses control of that capital, however, that could lead to major risks.

One other factor that is having a growing impact on emerging market equities is exchange-traded funds (ETFs).

ETF investors are notorious price takers – and they have an enormous place in the current investment environment. “The majority of investors allocating to emerging markets over the last 12 months have done so in underweight and by passive,” Duffy says.

And only a small portion of allocations have been active. That money “herds into a few large companies.” That top-heavy effect means that much of the capital flowing into emerging markets equities isn’t “distinguishing between value destroyers and value creators.” Of course, says Duffy that creates opportunities for active managers – “When there is a drawdown, there will be a capital draw on top which will serve active managers,” he adds.

Emerging markets and Trump

Asked about Trump’s trade stance at emerging markets, Duffy says that managers need to look for companies that can generate returns on capital under a range of stress situations – including changes in U.S. trade policy. However, he explains, “If we get border adjustments in emerging markets in a major way, you will feel pressures.” India, where the economy is 55% domestically driven will not experience the challenges of Mexico and Peru.

But the global economy is changing – as companies in China automate, manufacturing is moving to Malaysia and Bangladesh among other countries. Each region will have its own pressures, however, China is becoming a bigger player in Asian emerging markets countries.