While investors’ focus has seemingly been directed towards China – as its weight in global indices grows – this is an approach that may see them miss out on the growth, diversification, and income opportunities that smaller emerging markets offer.
At a time of continued global uncertainty, investors should not neglect the importance of diversification, writes Sam Vecht, co-manager of BlackRock Frontiers Investment Trust.
Yet, many emerging market portfolios are focused on a few dominant countries and stocks that are sensitive to global tensions and the news flow.
With the promise of broader access to countries that are often overlooked, and valuations that compare favourably to long-term averages, frontier economies may be on the cusp of a new dawn, after a period in which the asset class fell out of favour.
Improving fortunes
While external pressures remain from the unknown impact of coronavirus and brewing international geopolitical tensions, the breadth and diversity across smaller markets provide investors additional pockets of value in the current fluid, macro-sensitive environment.
This also comes at a time when low interest rates and coordinated fiscal stimulus have greatly improved liquidity – a factor that should benefit all developing markets as investors hunt abroad for returns and yield.
Identifying markets that are at the foothills of a change in fortunes can be powerful, as investors reap the benefits of an improving currency, stronger liquidity and a change in investor expectations.
This means looking at countries where bond yields are high, the currency is weak and GDP is lower.
However, these are also economies that are showing stronger signs: liquidity looks to be improving, trade balances are healing, and the political situation may be stabilising.
At times when the economy is improving, stronger companies usually see an influx of capital and are able to employ that additional capex to their advantage.
A useful byproduct of investing across these smaller economies is that it allows investors to engage with regulators and policymakers, passing on investment expertise that can help drive change to develop a more sustainable financial and social infrastructure for these communities to thrive.
Natural diversification
With imbalances at both country and stock level, this could be a good time to explore opportunities offered by smaller markets such as Indonesia, Turkey, and Egypt as economic conditions change.
They are very different to broader global stock markets and from each other. From a risk management perspective, this is helpful.
The coronavirus has demonstrated how correlation can increase at times of market dislocation and therefore the importance of true diversification.
When you have 16 to 17 different countries represented within a portfolio, each with different drivers of performance and growth, frontier markets exposure in aggregate can be surprisingly stable.
What’s next?
Going forward we think dividend cuts will likely impact emerging and frontier market companies more broadly, just as they have in developed markets.
By having a strong understanding of the business and management’s priorities, investors can be more selective to protect that component of total return.
What will change the fortunes for these markets?
It may be more confidence in global stock markets or global growth, or it may simply be that investors realise that they have become too cheap given the value on offer.
Either way, our view is that it is looking like we’re on the cusp of change.
This article was written for International Adviser by Sam Vecht, co-manager of BlackRock Frontiers Investment Trust.
