Equity investing in emerging markets: Navigating risks, seizing growth opportunities

Measures taken by the central banks across economies to tame persistent inflation have led to a unanimous fear that growth prospects in advanced economies (AE) are constrained for the year. The central banks of AE have raised the rates aggressively, limiting the room for the traditional tools in their arsenal.

In the US, the S&P 500 has recovered from the bottom; however, the gain was concentrated and driven by large-cap techs due to the euphoria around AI. We believe the earnings in the US are not multi-dimensional and consider the froth as mere premiums that are masking the opportunities in emerging equities.

The dollar strengthened last year, ascending to multi-year highs, and investors flocked towards high-yielding US assets. However, as the FOMC unwinds its tightening, the dollar will weaken relative to major currencies, and investors will scatter, looking for opportunities in global markets. Though global markets are clouded by uncertainty, specific emerging equities have structural tailwinds and are available at discounts further exacerbated by a strong dollar and present an opportunity.

The risk in emerging markets is that for every success story, there’s an economy ruined by poor governance or prone to geopolitical instability. Emerging nations or developing markets (DM) may depend on raw materials for economic growth, and the fluctuation in the commodities markets or cycles will be a drawback. A strong dollar can be a stumbling block for these economies, especially if the underlying is an increase in US interest rates. This can also be detrimental to nations if the debt is dollar-denominated, as it becomes harder to fund in such scenarios.

The question then arises why do investors prefer emerging markets despite such risks now more so than ever? The reason is several markets like India, Indonesia, Brazil, and others have flourished despite the pandemic, the Russia-Ukraine war, and monetary tightening in most advanced economies.

As per the Institute of International Finance, Global debt reached a record high in the first three months of 2023. However, the increase was majorly in developed markets, like the US, Japan, France, and the UK. The Debt/ GDP in the case of Brazil has been declining quarter on quarter, and for India has been moderating with improving fiscal deficits and higher GDP growth.

Barring the smaller economies that contribute less than 5 percent of global GDP, economies with structural changes, policies, and reforms that drive growth, have lower debt, contained inflation offer diversification to portfolios and better risk-reward opportunities have equities trading at discounts with the availably of new-age companies catering both upstream and downstream to the themes of the future.

Since the aggression of the pandemic, the lockdown across economies has led to a move coined as the China+1 strategy, diversifying the supply chain from China to economies like India, Indonesia, Thailand, and Mexico due to low cost and better skills. The pandemic accelerated the trajectory of digitization as corporates realized the importance of technology, and the ongoing digital transformation is a multi-year growth story, especially for emerging nations, as consumers increasingly adapt to Internet services, from digital payments to online education and shopping. This will have a multiplier effect across sectors as businesses improve their models and compete with the AEs.

The Indian economy, for example, is fundamentally stronger relatively with healthier corporate and household balance sheets. The policies and reforms by the government to make India a global manufacturing hub, investments in infrastructure with an outlay of Rs 2.34tn in Production Linked Incentive (PLI) schemes for key sectors, FTA’s signed with larger economies, and the focus on economic progress while targeting a Fiscal deficit of 4.5 percent by FY26 has improved the stable macro outlook to a multi-decadal growth opportunity.

In an unforeseen turn of events, headwinds of the past have now become tailwinds for emerging nations and economies like India, with a healthy banking sector, robust credit growth, strong domestic demand, deleveraged corporates, and the absence of excesses in the system leading to moderating inflation looks favorable.

This investment-led cycle in India will see growth opportunities in a credit growth environment. Further, as the central banks cut rates, foreign inflows into equities will result in the domestic market rallying to new highs. Smallcaps discarded in last year’s discriminate sell-off will likely outperform the large-cap peers over the next two to three years. While valuations are factored in for AE’s, EM equities are available at discounts with considerable headroom for growth. The combination of tailwinds for the economy, earnings growth, lower interest rates, and attractive valuations will enable Indian equities to justify commanding superior premiums in the years ahead. 

This article is authored by Prabhat Ranjan: Co-Fund Manager, Right Horizons, PMS and Vijay Chauhan: Co-Fund Manager, Right Horizons, PMS