Finding capital returns is a difficult challenge in a world of low growth expectations and low interest rates. Yet in this environment, emerging markets (EMs) can offer attractive access to equity growth potential.
Why invest in emerging markets?
The EM growth advantage
Emerging market economies are at the forefront of global economic expansion, continuing to monopolize the highest rates of real GDP growth available. According to the International Monetary Fund, emerging economies are expected to achieve average GDP growth of 4.9% over the next five years, two and a half times that of advanced economies (1.8%) or the US (1.9%).
India and China, for example, are expected to grow at 7.2% and 6.6% respectively this year. The outlook for US growth, at 2.3%, is considerably more modest. In fact, developing markets now account for more than 75% of global growth in output and consumption, almost double their share just two decades ago.
Strong secular trends
This economic growth reflects many of the strong secular trends that EM companies are benefiting from right now. Improving demographics provide a young, growing and increasingly well-educated workforce. Meanwhile, the rising middle class, specifically in urban areas, should continue to propel strong consumption growth.
The movement of people from rural to urban living is a particularly powerful driver for consumption and overall economic activity in emerging markets. In the next 30 years, India and China are expected to see the urbanization of over 600 million people, nearly 10 times the 70 Million expected during the same period in the US.
Trends such as digitization are also creating compelling long-term opportunities. Consider the phenomenal success of mobile commerce in China, for example. In 2016 alone, online retail transactions hit US$707 billion, dwarfing the US$385 billion in the US. And, although the Chinese market is already the largest e-commerce market globally, only half of its population is active online.
The tailwind of reform
In recent years, the emergence of more progressive governments and an increasingly assertive middle class have pushed the reform agenda in many EM countries. Stronger institutions and better-functioning societies have, in turn, driven improvements in the business environment and created a greater incentive for foreign direct investment.
This positive structural change has a material significance in the global investment context: It enables investors in emerging markets greater scope for identifying companies that can benefit from the kind of long-term earnings expansion associated with reform. This is a pathway to growth that is less prevalent in more mature economies.
Improvements in EM economic growth are already feeding through to earnings expectations. The recovery in earnings among EM companies that began in 2016 also looks to be quietly building momentum into 2017. This is evident from the most recent year-end results season and an increase in the number of companies issuing positive outlook statements for the year ahead.
Furthermore, this improvement is increasingly broad based. Initially it had been concentrated in the energy and materials sectors, but has now extended into industrials, consumer discretionary and financials.
The return on equity available in emerging markets may be bottoming out and is currently ahead of developed markets (Chart 1). Importantly though, price-to-book values remain low relative to historic levels and to developed markets (Chart 2).
At 12 times price-to-earnings, emerging market equities are considerably cheaper than US equities, which currently trade on 18 times price-to-earnings. If that gap narrows, as it has historically, the opportunity set may intensify.
Chart 1 -- Return on equity over past ten years: MSCI World v MSCI Emerging Markets
Source: Bloomberg, Martin Currie
Chart 2 -- Price-to-book over past ten years: MSCI World v MSCI Emerging Markets
Source: Bloomberg, Martin Currie
Given the positive drivers of strong economic growth, continued productivity improvements and the anticipation of looser financial conditions are all positive drivers, the momentum behind emerging markets appears to be sustainable.
How to harness global emerging markets
The ‘local’ advantage
Many investors still believe that they can get sufficient exposure to EM growth through developed-market multinationals that generate revenues in emerging markets. In our view, ‘clean’ exposure to local companies is a much more effective way to seize on the long-term opportunities these markets offer.
While many developed-world firms have made some penetration into emerging markets, for example, there are still significant barriers to entry that local companies do not have to grapple with. These include factors from domestic-production requirements and incentives favoring local businesses, to a simple lack of understanding of local market dynamics and tastes.
There are many attractive local companies operating in EMs that can offer that ‘clean’ exposure. And, in light of the increasing heterogeneity across emerging markets, local companies can also offer better potential for diversification both regionally and at the corporate level.
The active edge
While it is increasingly evident that the selection of local companies is increasing, there is still significant disparity in the quality of those companies. This means fully understanding what is material for a company’s idiosyncratic long-term performance – in particular, sustainability factors such as governance structures and environmental considerations – can meaningfully impact the investment outcome.
The bottom line is emerging markets are less efficient than their developed cousins, which creates both risk and opportunity. It means there is a significant informational advantage available through the kind of pragmatic engagement and careful stockpicking that is inherent in a truly active approach to investing in emerging markets.
 International Monetary Fund, World Economic Outlook, April 2017
 IMF, World Economic Outlook Database, April 2017
 World Bank, Health Nutrition and Population Statistics: Population estimates and projections, April 2017
 Martin Currie and FactSet as of 31 May 2017.