FAQ: Our active approach to emerging markets

In recent conversations with clients, I’ve fielded several questions about my team’s approach to emerging markets investing — including our underweight in China, our overweight in India, and our exposure to developed markets stocks. Here, I answer the questions I’m hearing the most.

The portfolio is underweight China. Can you discuss the reasons for that positioning?

China is more than a third of our benchmark,¹ and Invesco Emerging Markets Class is underweight China. One of the reasons is that we prefer not to have over 30% of the portfolio in any one country for diversification purposes. We obviously spend a lot of time examining the impact of macro and geopolitical forces on China and developing opinions about how these can affect our investments. We are mindful that the strained relationship between China and the U.S. is unlikely to improve in the foreseeable future, and this can influence not only how much we want to invest in China but also where we want to invest in China.

The ultimate driver of our exposure to China is the identification of companies that have the economic characteristics we seek — durable growth, sustainable advantage, a host of real options embedded in the franchise, and good governance. Although there has been an expansion of new investment opportunities in China over the last several years, broadly speaking, the benchmark is still composed of a lot of companies that we are not particularly keen on. These can be categorized in three different groups.

• The first are state-owned enterprises (SOEs) or state-influenced companies, which continue to be a sizable component of the benchmark. We generally avoid these companies in China and elsewhere in the developing world.
• The second are financials. In China, these companies often overlap with SOEs, and we believe they are largely un-investable for fundamental reasons.
• The third group is an intersection between cyclicals and industrials, which is really not our forte anywhere in the world.

Despite the underweight and the avoidance of these areas, the portfolio reflects some high conviction decisions in China. Can you discuss the overall exposure? 

Our holdings in China can be divided into three buckets. The first is what we consider to be anti-fragile companies. These are companies that have been under enormous stress over the last few years because of the extreme mobility restrictions associated with the pandemic. That stress has improved their competitive position, spurred faster near-term growth, and resulted in better pricing, margins, and cash flow. The analogy I often make is to strength training, which breaks the muscle down but ultimately builds it back stronger. The companies that fall into this category are Yum China, the largest quick service restaurant chain in China; H World, one of the largest hotel groups; and ZTO, one of the largest express delivery companies.²

The second bucket is a bit more diverse. We have two large technology holdings — NetEase, the game developer; and Tencent, the internet services leader — both with strong franchises in their respective areas.³ And then we have a cluster of drug and biologic manufacturing companies that are beneficiaries of tremendous industry tailwinds and company innovation — Wuxi Biologics and BeiGene are the two largest positions there.⁴

You mentioned ownership of Tencent, but most other Chinese internet companies are absent from the portfolio. Can you discuss the rationale behind that?

Chinese internet stocks comprise 10.2% of the MSCI Emerging Markets Index.⁵  Our exposure to the industry is well below where it has been historically due to a few competing variables. We’ve seen signs of improvement in the last 12 months that are quite positive for the Chinese internet services sector. The regulatory environment has become clearer after the disruption of the past two to three years; content approval, particularly for new games, has become much less burdensome; and the monopolistic characteristics of the industry have been moderated. Additionally, over the next several months, China could see a post-COVID cyclical economic recovery that would benefit the advertising industry, which is the backbone of a lot of the value in the Chinese internet space.

These positives are balanced by the fact that China, unlike the rest of the world, continues to be a place of extreme competitive aggression. These internet companies are well-funded, they're incredibly audacious, and they are aggressively fighting for market share in highly penetrated markets of advertising and e-commerce. For example, ByteDance, the owner of Tik Tok, is taking significant market share in short form video, while well-established companies Alibaba and JD.com are bleeding market share to PDD, a relative newcomer.⁶

There will be some changes in response to this difficult environment. In March, Alibaba announced that it will decouple the empire and allow its business groups to run with greater autonomy with an eye to individual IPOs for those groups. In my view, this is more about financial engineering to crystalize some near-term value for investors rather than the overhaul required to address the competitive stresses that they face. This isn’t a circumstance that we’re interested in. That said, we keep an open mind and continue to have a healthy dialogue with the company.

India is one been one of the largest overweights in the portfolio. People have often referred to India as the next China. Is that a real possibility? And how does it influence your exposure to the market?

India represented 19% of the portfolio at the end of April. We have never held the view that India could replicate China's experience. Our approach is about investing in a cluster of unique companies that operate in a continental-sized economy and are well-equipped to take significant market share. In the last two or three years idiosyncratic opportunities to own great companies in India are now supported by the Modi administration’s embrace of economic reforms, which have untethered India’s domestic growth potential.

As a result of the creation of economic zones, increased availability of credit, and labour reform, India now has the potential to become a significant low-cost manufacturing hub. This capability comes at a time when many manufacturers are more intently looking to diversify supply chains. India, for the first time, will be able to grab some market share from China that previously went to places like Bangladesh and Vietnam. Apple’s recent announcement that it would move some of its iPhone manufacturing to India could be just the tip of the iceberg.

Our two Indian financial services companies, HDFC and Kotak, are pioneers in the industry.⁷ (Read more: HDFC: The rare merger that makes perfect sense) Their strong franchises, underwriting practices, and balance sheets have allowed them to take market share from the public sector banks and create very durable moats. The higher levels of sustainable economic growth that we expect from India should translate into a beneficial tailwind, leading to significantly higher asset prices and corporate loan growth.

The portfolio has exposure to non-emerging market (EM) domiciled companies. Why would an emerging markets portfolio invest in developed markets stocks?

In our search for extraordinary companies, we are willing to invest up to 20% of the fund’s assets in developed market companies whose earnings, cash flows, and growth are dominated by the developing world. As of April 30, 2023, we had 15% of the portfolio in those kinds of companies.

Ultimately, our strength is in identifying possible long-term winners, which are companies that have those unique characteristics that I mentioned earlier. The fact is that some of the very best businesses in places like India, China, and Brazil happen to be domiciled elsewhere. For example, the best bank in Mexico happens to be owned by the Spanish company BBVA.⁸  In India, the greatest spirits businesses are owned by Pernod Ricard and Diageo.⁸ (Read more: Western spirits companies turning to China and India to fuel growth) China has become one of the world’s largest luxury goods markets, but all of those companies are domiciled in Europe. We want to participate in these amazing EM growth opportunities.

Investors have historically associated U.S. Federal Reserve (Fed) tightening with a negative outlook for EM equity performance. That does not seem to be playing out this cycle. Why is that?

For most of my 30-year career, many investors viewed EM equities as a beta play on the global economic cycle. Money aggressively moved into EM in environments where global industrial production, trade, and growth were good and then retreated when the Fed, for whatever reason, needed to tighten monetary policy. Following that formula, one would have expected that the Fed’s massive monetary policy response over the past year to address high levels of inflation in the U.S. would lead to a big emerging market economic crisis, falling currencies, and collapsing equity markets. That has not happened this time. 

I think what has fundamentally changed is that EM assets have largely been neglected for the past decade. The lack of hot money meant there was no creation of bubbles (though China might be in a slightly different phase) in terms of credit, current account deficits, or other imbalances that tend to pop up when EM is in favour. In fact, most emerging market economies, including classically volatile circumstances like Brazil, are actually sitting on very healthy external accounts; there hasn't been a large amount of domestic credit growth in excess of nominal gross domestic product (GDP); and we haven't seen ballooning asset levels. So, EM equities have evolved from being the world’s beta play to offering slower growing but more resilient economies. Coupled with attractive valuations, we believe that creates a very compelling investment opportunity for active investors.

EM valuations have looked attractive for some time. What is the catalyst to see a re-rating in the asset class?

I think emerging market equity valuations look extraordinarily attractive on a relative basis and I see a few catalysts that could crystalize that value. One is an improving growth backdrop. Many EM central banks have been well ahead of the Fed in tackling inflation with monetary policy tightening. These economies have borne the adverse effect of high real rates for well over a year, resulting in decelerating economic and corporate growth, and weak asset prices. As inflation peaks, EM central banks should be the first to cut, and it is possible to see a scenario where growth accelerates in EM — both earnings and GDP — at the same time that it decelerates, or stagnates, in the developed world.  

Another positive could be a weaker U.S. dollar environment, which would obviously be quite favourable for non-dollar assets. I’m actually quite bearish on the U.S. dollar. The U.S. has significant imbalances (the fiscal position is grim and getting worse), there is a structural current account deficit, and asset prices appear poised to retreat. Additionally, global central banks continue to diversify their reserves away from the U.S. dollar (this is one of the reasons gold has been so strong of late), and we’re seeing growing calls to conduct trade in local currency as opposed to the USD. None of this means that the U.S. dollar will be sidelined anytime soon, but the trend is clear.

Finally, when you think about the biggest winner in the past decade, it has largely been U.S. assets. We believe that level of outperformance is unsustainable, and valuations appear stretched. Within the U.S. (and to be fair, globally), the winners of the past decade were long duration assets that benefited from a very cheap cost of capital — think real estate, private equity, technology, and other beta plays. In a rising rate environment, where valuations and fundamentals begin to matter again, beta/momentum investing becomes very challenging — this bodes well for high quality EM assets.

Additionally, the world is a more complicated place with the frictions of geopolitical tensions, changing domestic policies, the ramifications of the energy transition, and deglobalization. In our view, successfully navigating these changes requires active managers who focus on generating idiosyncratic alpha.