How To Harness Emerging Markets And Sleep At Night

How To Harness Emerging Markets And Sleep At Night

Investing in infrastructure can be one of the most direct ways of capturing emerging markets (EM) growth. With improved regulation and a growing amount of assets, EM companies are an increasingly attractive part of the global listed infrastructure universe. Charles Hamieh, Senior Investment Analyst and Portfolio Manager at RARE Infrastructure explains the scope of the sector.

Investors’ experience in emerging market (EM) equities has not always matched their expectations. Hopes of returns that resemble the booming growth in Gross Domestic Product (GDP) can fall short when high wage demands and inflation eat into profitability and shareholder returns. In addition, investors have suffered higher volatility than in other global equities in both up and down markets; the standard deviation of the MSCI Emerging Markets Index (USD) is 22.8% over 10 years to 29/12/17, while for the MSCI World it is 16.3%.

For potentially lower-volatility EM returns companies that own domestic infrastructure assets may offer a solution. Listed EM infrastructure companies capture 81% of market rises on the MSCI EM Equity Index, but only 51% of market falls over the past nine years, according to analysis from RARE¹.

EM infrastructure companies may also enable investors to capture  economic growth. For example, airport companies are likely to have their revenue linked to rises in domestic growth and demand.

Finally, infrastructure can also offer the potential for a decreased exposure to inflation. Many utility companies are allowed by regulation or long-term concession contracts to raise the price of their services to keep up with inflation.

 

A building boom in EM infrastructure

EM infrastructure looks to be at the beginning of a long market cycle, as expanding EM economies put in place plans to create greater supplies of water, energy, roads and communications.

These drivers are expected to push the value of EM infrastructure to outstrip developed-markets infrastructure assets by 2030, according to research by David Hale Global Economics, in conjunction with RARE. This expansion is predicted to take the value of public and privately-owned infrastructure assets worldwide from US $22 trillion in 2014 to US $60 trillion in 2030.

 

Value of Global Infrastructure Assets By Sector

Value of Global Infrastructure Assets By Sector

Source: David Hale Global Economics (2014) and RARE.

The rate of EM economic growth is key to this change. The International Monetary Fund forecasts the GDP of emerging market countries to rise from 4.6% in 2017 to 5% in 2020. By contrast, developing countries are expected to grow by 1.7% in 2020, a fall from 2.1% in 2017.

 

How can investors take advantage of this opportunity?

EM governments want to build infrastructure for their economies but cannot always afford to pay for it. They know that more and better infrastructure allows fast transportation of goods; uninterrupted electricity distribution allows smoother production and greater mobile phone coverage allows better communication.

Where they cannot afford to pay, there is a growing trend towards privatising assets to fund new investment and to target improved efficiency. This is giving an increasing scope for private investors to own such assets.

RARE believes the best chance of capturing economic growth, along with the potential for moderating inflation and volatility, is through a stock-picking approach. This limits selection of companies to those that own hard, physical assets, with a high proportion of revenue arising from activities providing an essential service to society or an economy. These companies are also screened to ensure they have predictable revenue streams derived from regulatory or contractual frameworks. This approach is more selective than indices such as the S&P Global Infrastructure Index.

As part of its due diligence RARE gains a good understanding of the local regulation that governs infrastructure assets. This informs it on the direction of policy making and helps in assessing the long-term value of assets.

Keen knowledge is important in emerging markets where best practice is still being established. Brazil is a good example. Five years ago, it tried unsuccessfully to raise large sums of money for infrastructure projects that presented tough terms and relatively ambiguous regulation for investors. The standard of regulation has now improved and with it, the amount of overseas investment. This has led to RARE making Brazilian companies an increasing part of its portfolios.

 

The role of infrastructure in a portfolio

Well-chosen EM investments within a global portfolio of infrastructure stocks can be used by investors as a means of gaining a more attractive income and for higher growth that still has lower volatility than equity markets. However, one of the potential risks for investors is such stocks losing value at times when interest rates are expected to rise, although this can be a buying opportunity too - the beauty of being a global investor is rates generally do not rise everywhere simultaneously offering alternative opportunities. In addition, investors will also be open to both negative and positive currency fluctuations.

 

Conclusion

For investors seeking to track rising emerging markets growth while potentially minimising the downsides from high volatility or local inflation then listed infrastructure is worth consideration. When blended into a well-diversified portfolio of global listed infrastructure stocks, carefully selected EM stocks can also offer a greater variety of income and returns. 

 

¹ These figures are based on returns from 30/9/2008 to 30/06/17 in Australian dollars and use RARE’s analysis of companies within its EM Infrastructure Fund to compare with the MSCI EM Equity Index.

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