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THE RISE AND RISE OF INDIA PAGE 8

2022: A YEAR TO REMEMBER? PAGE 6

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eMeRGInG MARkeTS

An exclusive report in association with Templeton Emerging Markets Investment Trust

11 March 2022

Lands of opportunity EMERGING MARKETS – BEYOND THE INDEX PAGE 4

Emerging market economies generate 65% of global growth

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If you are looking for a long-term investment that harnesses this dynamic growth potential but are not sure how to access it, consider Templeton Emerging Markets Investment Trust.

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Tem Templeton Emerging Markets Investment Trust Mark Your future is emerging

Value of investments can go down as well as up, investors may not get back the full amount invested. Emerging markets can be riskier than developed markets.

This advert is not investment advice. We recommend seeking financial advice before investing. Issued by Franklin Templeton Investment Management Limited (FTIML), Cannon Place, 78 Cannon Street, London EC4N 6HL. FTIML is authorised and regulated by the Financial Conduct Authority. *Source: IMF WEO, October 2021. †Source: Morningstar as at 16 November 2021. ©Morningstar Inc, 2022. All rights reserved.

Editor’s letter

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Going for value and growth

The case for emerging markets is often built on the growth case – but value matters too

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elcome to this special report on emerging markets, produced in association with Templeton Emerging Markets investment trust. One classic argument for investing in emerging markets is that investors should go where the growth is. These rapidly-growing economies – several of them existing or budding superpowers – are much more exciting than those in the sclerotic developed world. Why wouldn’t you want to invest in them?

It’s absolutely fair to say that emerging markets are where we’ll see the most future economic growth. It’s hard to see how it could be otherwise, given that – to consider just one data point – the vast majority of the world’s youth lives in emerging economies. There are plenty more statistics where that came from. I could easily fill this column with them.

However, there’s a lot more to the case for emerging markets than just their sheer growth potential. To my mind, there are really two key things to grasp here. The first is a point we make throughout this supplement – there’s no such thing as a “typical” emerging market. The ageing “Brics” acronym, which irrevocably bundled Brazil, Russia, India and China together in the popular investment imagination, amply demonstrates the absurdity of treating these countries as a homogenous mass. The four had little enough in common when the acronym was first coined and have diverged even more sharply since then. Different markets offer different exposures to key sectors – so you have to be picky, to use a technical term.

My second key point is this: there is another factor, beyond growth, which is absolutely critical to future returns. That’s valuation. If you buy an asset when it is cheap, then history suggests your longterm returns will be greater than if you buy when an asset is expensive. On that front, the good news is that in recent decades, the US market has left all others standing. As David Stevenson notes on page 5, many emerging markets have lagged and now look inexpensive as a result.

Could 2022 be the year in which they play catch-up? We don’t have a crystal ball – but if we had to place bets on whether the US will outperform the rest of the world from now in quite the way it has since the financial crisis, we’d be taking the short side of the trade. We’d suggest allocating at least some of your portfolio to emerging markets instead.

John Stepek editor@moneyweek.com

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Contents 4 Emerging markets

The term “emerging markets” is a useful label for economists, but investors in these countries should be wary of falling prey to “framing bias”.

David Stevenson explains why and how to avoid it.

6 2022 and beyond

Emerging markets saw a mixed performance in 2021, with China in particular casting a shadow over sentiment. Will 2022 prove a good buying opportunity?

Max King reports.

8 Country focus: India

The Indian stockmarket had an excellent 2021, beating both China’s main market and the emerging markets index in general. There’s plenty more where that came from, says David Prosser.

9 Inflation

Inflation is becoming a serious issue across the world, leading to concerns about how higher interest rates – particularly in the US – could affect emerging markets. So should investors be worried?

David Stevenson weighs up the evidence.

10 Technology

Silicon Valley is seen as the heart of the technology industry. But when it comes to innovation, emerging markets are catching up or even leading the way in several key areas, says David Prosser.

11 Semiconductors

Semiconductors are critical to almost every aspect of modern life, as the recent supply crunch makes plain.

And one emerging market – Taiwan – lies at the heart of this supply chain. Simon Wilson reports.

14 Index tracking and emerging markets

Passive funds offer a cheap way to track an underlying index, and have become very popular, particularly in developed markets. But passive might not be the right approach to take for emerging markets – here’s why.

11 March 2022

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Emerging markets

What is an emerging market?

The answer’s not as easy as you think

©Getty Images, Shutterstock

Emerging markets is a useful term for economists, but when it comes to investing, you need to dig a lot deeper.

There’s no such thing as a “typical” emerging market David Stevenson Investment columnist

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here’s a well-known cognitive (or behavioural) bias called “framing bias”, defined by the CFA Institute as “when someone makes a decision because of the way information is presented to them, rather than based just on the facts”. I like to call it the “Tupperware bias” – our need as investors to parcel up complex phenomena into nice, easy-to-access boxes with handy labels.

Beware of neat little boxes

“Not all countries defined as ‘emerging’ are in the benchmark”

The term “emerging markets” (EMs) is a perfect example of this bias. We all understand that there’s a group of distinct developed economies boasting developed stockmarkets, full of individual equities. Then there’s a developing world, where well-known markets such as Brazil and India are jumbled up with lesser-known ones such as Mexico or Malaysia. These started to be called the “emerging markets” largely due to then-World Bank economist Antoine van Agtmael who came up with the term in 1981 as an alternative to “third-world countries”, which had acquired negative connotations. Today, according to the World Bank, more than 160 nations – 80% of the total – are classed as “emerging”. This classification is mostly based around wealth, expressed as gross domestic product (GDP) per capita.

Clearly this blanket term covers lots of very different countries and markets. Some are huge, such as the four nations popularised as “the Brics” by Jim O’Neill, then a Goldman Sachs economist: Brazil, Russia, India, and China. But these big names are just a fraction of a much larger universe that takes in another Goldman term, the “Next 11” (which covers places as diverse as

Mexico, Turkey, and Pakistan), before heading even further down the pecking order to nations and markets that bridge the divide between emerging and “frontier” – frontier markets being those with less developed economies and stockmarkets, including most of those in Africa (bar South Africa, of course).

When an EM isn’t an EM

Yet for many investors, “emerging market” implies a much narrower definition: the countries (and their accompanying large stocks) included in a global benchmark index such as the MSCI Emerging Markets index. According to index provider MSCI, this “captures large and mid-cap representation across 25 emerging markets countries” with 1,422 constituents, representing about 85% of the free float-adjusted market capitalisation in each country.

There are two relevant points for investors here. The first is that not all countries defined by the World Bank, say, as “emerging” make it into the MSCI index – for a country to qualify, it has to meet various criteria on stockmarket liquidity and regulation. Only 25 pass that test. The other key point is that it’s an index based around market capitalisation – so if there’s a handful of very valuable companies in the tech sector, say, then these companies will dominate the index.

But sometimes the index throws up surprises. In 2014, China’s Alibaba listed in the US, and initially wasn’t included in the MSCI EM index. A similar index compiled by FTSE only added the Chinese tech giant in late 2017. Anomalies continue to this day. South Korea is included in the MSCI EM index and Samsung is the third-biggest company, even though many would regard South Korea as a developed world market.

Many argue the same for Taiwan. At the other end of

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Emerging markets

A narrow view of EMs

So far, so exciting – but the table, above right, looking at returns from various broad indices over the past decade, paints a very different picture. It shows returns from the MSCI EM index versus the developed world version (MSCI World) and a composite of the developed

MSCI EM sector weights Other 18.9%

IT 21.8%

Energy 5.8%

Financials 20.8%

Materials (mining) 8.7% Communication services 10.9%

Consumer discretionary 13%

MSCI EM nations Others 23%

China 32.1%

Brazil 4.6% South Korea 11.7% India 12.5%

Data correct as of 31 January 2022

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Taiwan 16.1%

and emerging world (the ACWI). You’ll immediately notice that the EM index has underperformed, with huge volatility.

2021 -2.5% 18.5% 21.8% So if the potential is so huge, why the 2020 18.3% 16.2% 15.9% disappointing numbers? The answer goes back to our point on framing bias.

2019 18.4% 26.6% 27.7% As the pie charts, below left, show, for 2018 -14.6% -9.4% -8.7% benchmark-focused investors, “emerging markets” actually means a narrow band 2017 37.3% 24.0% 22.4% of technology and financial names: IT 2016 11.2% 7.9% 7.5% and financial firms comprise just under 2015 -14.9% -2.4% -0.9% 45% of the MSCI EM universe. It also means a focus on what we might call 2014 -2.2% 4.2% 4.9% “Greater China” – countries that engage 2013 -2.6% 22.8% 26.7% very heavily in trade with China, such as South Korea and Taiwan. This trio 2012 18.2% 16.1% 15.8% comprises around 60% of the index.

Obviously, China and its middle classes are a hugely “Look important – but there’s also a fast-growing middle class in India, embracing technology at an astonishing rate beyond the (see page 8) while Latin American countries such as index to Brazil boast wealthy middle classes as well as hugely profitable resource-led industries that are currently uncover less booming. Yet India and Brazil comprise just 17.1% well-known of the index. That’s ignoring the likes of Malaysia, Indonesia, Thailand, Mexico and many others which growth don’t even make it onto most big investors’ lists. stories” To reiterate, there’s no such thing as a typical emerging market. If you want to access the world’s largest group of consumers, with the fastest growth in personal wealth, you’ll need to look beyond the index to uncover the less well-known growth stories out there, from Brazilian resources companies to Indonesian internet businesses. And to profit from this vast universe you’ll almost certainly need a fund with the expertise to avoid the framing bias we outlined in the introduction.

Year

MSCI EM

MSCI ACWI

MSCI World

I wish I knew what purchasing power parity was, but I’m too embarrassed to ask Purchasing power parity (PPP) is a theory that tries to work out how over- or undervalued one currency is relative to another. It does this by comparing the price of identical goods in different economies. The idea is that a similar basket of goods should cost roughly the same wherever you go.

Why? Because if goods are cheaper in one country than another, then that country should be able to export them to the other for a profit.

In turn, those sales would boost demand for the exporter’s currency, driving the exchange rate higher, and eliminating the difference between the two. As a result, purchasing power between countries should tend towards parity in the long run.

The best-known PPP currency indicator is the “Big Mac index”, published by The Economist since 1986. It shows the value of a McDonald’s Big Mac burger in US dollars, all across the globe. Clearly the index is not especially scientific, but as a Big Mac is a product that can be bought in almost any country in the world and is comprised of the same input costs (raw materials and labour) and is distributed in almost

11 March 2022

©Shutterstock

the scale, a fast-growing country like Vietnam is not in the index because its stockmarket doesn’t pass key tests around listing rules.

These points are worth labouring because many investors either use the MSCI EM as a benchmark or invest in it directly via tracker funds, assuming that it gives them broad exposure to “emerging markets”. But what they are in fact buying into is a very narrow bit of the developing world, one dominated increasingly by Chinese stocks, many of them in the technology sector, and very skewed towards mega-large-cap businesses. In short, by using an index, it’s easy to miss out on a wider opportunity set of stocks, markets and countries.

On this point, a few years ago, analysts at the McKinsey Global Institute looked for the topperforming countries (by per-capita GDP growth) in the emerging universe, over the 50 years from 1965.

Of these, 18 were identified as outperformers, with just seven achieving or beating “real” annual per-capita GDP growth of 3.5% for the entire 50 years: China, Hong Kong, Indonesia, Malaysia, Singapore, South Korea and Thailand – note that most emerging market indices have only minimal exposure to Malaysia and the latter three countries. They identified another five countries who saw at least 3.5% annual per capita growth between 2011 and 2016: Bangladesh, Bolivia, the Philippines, Rwanda and Sri Lanka. Again, these five barely figure in most emerging market indices.

The analysts also asserted that emerging economies overall would “represent 62% of total consumption growth between 2015 and 2030, the equivalent of $15.5trn, with 22% of that coming from China alone”.

By 2025, they added, “annual consumption in emerging markets will reach $30trn – the biggest growth opportunity in the history of capitalism”.

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exactly the same way wherever you go, it’s as good an approximation as you’ll get.

Say a Big Mac costs £3.29 in the UK and $5.66 in the US. If the exchange rate is $1.36 to the pound, that would mean a Big Mac in the UK costs just under $4.50, suggesting the pound was about 20% undervalued relative to the dollar.

PPP is useless as a trading tool – like most other assets, currencies can stay out of line with their “fundamental” valuation for far longer than seems sustainable.

However, using PPP to adjust GDP figures can be a useful way for economists to compare GDP between nations without the distorting impact of relative currency valuations, which can make living costs look higher in developing countries than they really are.

in association with Templeton Emerging Markets Investment Trust

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EMs outlook

Will 2022 be a year to remember for emerging market investors?

After a mixed 2021, is this a once-in-a-generation buying opportunity for EM shareholders?

Max King Investment columnist

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or those who remember the heady optimism about investing in emerging markets (EMs) of earlier decades, recent years have been a cruel disappointment.

As Ruchir Sharma, former chief global strategist at Morgan Stanley, pointed out in the Financial Times recently, “after their worst decade since the 1930s, emerging stockmarkets continued to underperform as a group in 2021, deepening the isolation that surrounds this sprawling asset class”.

Emerging market equities, with their poor recent performance, complexity and risk, covering a huge range of companies in dozens of countries that are diverse in every conceivable way, have become an easy asset class for professional as well as private investors to ignore. They account for more than half of the countries in the MSCI ACWI index but just 12% of its value – of which China is nearly a third. The US alone represents over 60% of the index.

This is not the outcome that was projected in “the Brics dream”, the research compiled by Jim O’Neill (then of Goldman Sachs) 20 years ago. This paper projected the economic and market development of the four largest emerging markets – Brazil, Russia, India and China – over the next 50 years. The research was extended two years later to include South Africa and, a further two years later, the “Next 11,” namely Bangladesh, Egypt, Indonesia, Iran, Mexico, Nigeria, Pakistan, Philippines, South Korea, Turkey and Vietnam (several of which are categorised as “frontier” rather than “emerging” markets).

A brief history of emerging markets

Just 20 years earlier, emerging markets were starting to appear on investors’ horizons with the more intrepid managers, notably Mark Mobius of Templeton, telling investors that countries such as Thailand, Brazil and Malaysia were rather more than attractive holiday destinations. Templeton launched its investment trust (TEM) in the late 1980s and many global, regional and country funds and trusts followed.

So narrow was the opportunity set that Brazil, Malaysia and Mexico accounted for more than 60% of the MSCI Emerging Markets index in 1989. The collapse of the Berlin Wall led to the opening up of Eastern Europe and the former Soviet Union, which prompted countries such as India, South Africa and Taiwan to open up to global investors too.

The development advice to emerging economies was to introduce convertible currencies, a stockmarket and privatisation plans, accompanied by deregulation, the

Emerging markets: will bulls or bears win this year?

reduction of trade barriers and low taxes. The result would be strong growth and broadening prosperity.

Democracy would keep governments in check; if not straight away, then later, when rising living standards raised popular aspirations.

The Tiananmen Square crackdown in 1989 showed that China would not tolerate democracy but it was assumed that an increasingly urban, educated and wealthy population in contact with the wider world would eventually change the political system. China’s acceptance of the market economic order seemed to make this inevitable. The ensuing decades were not short of political, economic or currency turmoil, but the trend of accelerated growth, a rapidly-growing middle class, sharp falls in poverty and the spread of democracy globally continued. Investors in emerging markets had started with “BBC” – banks, brewers and construction companies – but this soon broadened to encompass resources, telecoms and consumer stocks.

There were sceptics who believed the best way to invest was through developed market companies with significant operations in emerging economies, such as BAT, Unilever and Diageo. Veteran investor Nils Taube, who described himself as “the only Old Estonian in the City”, continued to advise against “investing in countries where you don’t need an overcoat in winter”.

But most investors accepted that emerging markets were increasingly important.

“Goldman Sachs’ Brics A progress report on the Brics This was the backdrop to O’Neill’s research. The Brics forecasts group’s share of global GDP at purchasing power parity didn’t turn (see page 5) – 23.3% in 2001 but only 8% at prevailing rates – was expected to more than double out too exchange by 2050, by which time exchange rates would broadly badly” reflect purchasing power: that is, Bric currencies would

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EMs outlook

©Shutterstock

“Fund managers point to attractive valuations for emerging markets”

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than more democratic and less effective than hoped for in promoting prosperity.

The assumption that economic progress would be reflected in equity markets has also, as Goldman Sachs warned, proved false. Developed market companies have proven adept at globalisation while many previously state-owned domestic companies, though partially privatised, remain under political control or hamstrung by political interference – like EDF in France. Worst of all has been the example of China, direct and indirect. Having grown to account for over a third of the emerging markets index, its bear market this year has had a significant impact, driven partly by a government crackdown on internet and education companies. China is offering other emerging economies an alternative path to prosperity which does not involve the sacrifice of political control or the “privileges” that brings. Kowtowing to the developed world’s model of development and to Western investors is not necessary.

China stands ready to offer a helping hand to those who choose to follow a different path.

A compelling outlook for the long run

rise against the dollar by about 2.5% a year. Implicit in Goldman Sachs’ projections was a reminder to the developed world that as the relative economic power of the emerging world increased, so would its political influence. Goldman warned in 2005 that “local markets may not be the best vehicle for the local growth story”. Still, “within a decade [the] Brics’ market capitalisation could be four times bigger than today”, while “[the] Brics’ share in a benchmarked global portfolio would rise, perhaps to as much as 17%”.

In economic terms, these forecasts have not turned out too badly. With nearly 30 years to go, China is well ahead of expectations and India is on course, but Russia is well behind and Brazil has gone backwards. But in stockmarket terms, emerging markets have fallen way behind. The “Next 11” have also had mixed fortunes.

South Korea is, de facto, now a developed economy (despite its classification as an emerging market).

Vietnam (still deemed a “frontier market”) is booming, Egypt is struggling, Turkey has seen its currency collapse and the inclusion of Iran is just an embarrassment.

The disappointing equity performance is, to an extent, due to a US renaissance. Fracking has flipped the US from energy importer to exporter while renewables have reduced the energy constraint on developed economies. In media, consumer services, healthcare and autos, US companies have proved to be the world’s best innovators. China has built a significant presence, helped by protection, the Chinese language, culture and politics, but globally successful companies elsewhere are comparatively few.

In emerging economies, as elsewhere, nationalism and populism have had an enduring appeal while voters are eager to punish mistakes and reluctant to tolerate short-term pain for long-term gain. Many governments have become more authoritarian rather

Yet this does not appeal to everyone, especially not to those who are doing just fine or who prefer the traditional market-led approach, perhaps with local twists. This leaves ample opportunity for emerging market specialist funds to offer a compelling investment proposition. The best managers are not beholden to the benchmark, preferring to focus on individual stocks – as one manager points out: “If it’s a great business, it doesn’t matter where it’s located.”

Active managers also have the ability to “overweight” the most promising sectors – information technology now accounts for over 20% of the MSCI EM index, for example, but contains some of the most compelling investment ideas (see page 10). The consumer, communications and healthcare sectors are of growing importance while sectors such as financials are less mature than in developed markets. In short, in a region that accounts for 65% of global growth, around 60% of the global economy and 85% of the world’s population, there is plenty of opportunity.

Is this a once-in-a-generation buying opportunity, is it too soon, or are emerging markets destined to fade back into obscurity? Most analysts are sitting on the fence, advising caution. They warn that rising US interest rates usually push up the dollar, sucking liquidity out of emerging economies. They fear the impact of new variants of Covid-19. They point to rising inflation (see page 9), political turmoil and poor national finances, with multiple country examples.

Ruchir Sharma, however, notes that “the media tends to dwell on troubled cases, such as Turkey”, adding that the emerging market index was dragged down in 2021 by the poor performance of China, which lost over 20% in dollar terms. But “it will come as a surprise to many that eight of the top ten and 13 of the top 20 best-performing markets of 2021 were in the developing world”, notably India, Russia, Taiwan, Mexico and Vietnam. “If the fundamentals driving commodities, manufacturing, data flows and economic reform hold up, 2021 could be remembered as the year an emerging market comeback began, even if it was not widely recognised at the time.”

Fund managers, meanwhile, point to attractive valuations. The MSCI EM index trades on 13.3 times 2022 earnings (expected to grow at a compound rate of 13% in local currency over the next five years) and has a dividend yield of more than 2%. The corporate return on capital, at 12.7%, is competitive and the valuation of two times book value (the valuation of companies’ assets in their accounts) is modest. For longer-term investors, these are compelling numbers.

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11 March 2022

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India some efforts to simplify India’s notoriously complex tax system. Financial incentives for manufacturers have helped smaller firms in particular. And foreign investors have been encouraged by the government’s willingness to back away from retrospective taxation.

The result has been a surge in corporate earnings; one recent Morgan Stanley estimate was for annual profits growth of 24% a year over the next three years. Economic growth is accelerating too. The International Monetary Fund thinks the Indian economy will expand by 9% this year and 8.1% next; that would make it the world’s best-performing large economy. In the longer run, the spending power of India’s middle classes is growing at pace, offering the prospect of increased consumption for years to come.

World Data Lab says India’s middle class will grow by 8.5% a year until 2030; from less than 400 million people today to more than 800 million by 2030.

©Shutterstock

A broadening range of opportunities

India: IT prowess is just one of its many strengths

Focus on India: the sleeping giant wakes

That should help India broaden its economy. For some years, India has been associated with information technology. Its giant consultants, such as Tata and Infosys, certainly fared well during the pandemic as the world has needed support with digital transformation. But a new generation of businesses is now growing rapidly. Retailers, for example, along

India pulls ahead

Stockmarket indices, 1 January 2021 = 100 $ terms

130

BSE Sensex 30 India

120 110

Indian markets had an excellent 2021. The good news is that there’s plenty more where that came from David Prosser Business Columnist

“India’s middle class will double in size by 2030”

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omething is changing for investors in Asia. For years, the rise of China has been the region’s dominant theme, delivering stellar returns for those who backed its high-growth companies. Now however, concerns over corporate debt in China, and the property sector in particular, alongside the government’s increasing interventionism mean that suddenly it is India that is catching investors’ eye.

No wonder. While China’s main stockmarket index fell last year, India’s soared. The BSE Sensex 30 index was up by almost 22% over 2021 as a whole, ahead of the MSCI Emerging Markets index, not to mention most developed markets.

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Slow but steady reform

For some investors, the question might be: “What took you so long?” Just 40 years ago, India’s GDP per head was almost twice China’s; by last year, that picture had completely reversed. The Chinese government’s determination to pursue economic reform from the 1980s onwards left India – stymied by bureaucracy, regulation and protectionism – trailing in its dust.

Still, the momentum does now seem to be shifting. Prime Minister Narendra Modi’s government has its critics, but successive election victories in 2014 and 2019 have at least brought much-needed political stability. They have also given Modi the confidence to begin to liberalise the economy. Tax reforms, for example, have included a cut to corporate rates and

100

Shanghai Composite J

F

M

A

M

MSCI Emerging Markets J

J

A

S

O

2021

N

D

90 80

J F 2022

Source: Refinitiv Datastream, The Economist

with their supply chains, stand to benefit as the middle classes open their wallets. Homebuilders are seeing similar dividends, helped by improved access to credit due to growing competition in the banking sector, including from digitally-enabled start-ups. Healthcare is another exciting area. India’s role in producing so many of the world’s Covid-19 vaccines has underlined the strength of its pharmaceuticals sector, which includes growing numbers of innovative biotechs.

There are risks, of course. A major challenge is the climate change imperative; Delhi’s polluted streets offer very visible evidence of India’s addiction to fossil fuels. Modi has promised that India will reach net zero on carbon emissions by 2070. Critics would have preferred a more ambitious target, but even 2070 will be tough. That said, India’s fast-growing renewable energy sector offers some hope, as well as further investment opportunities.

Valuation is another concern. Some investors may consider Indian shares expensive after last year’s bull run. The market certainly has a record of lurching from feast to famine. Long-term investors have been very well-rewarded, with annualised returns of more than 15% over the past two decades, but there have been plenty of thrills and spills. Nevertheless, for many long-term India watchers, the country feels as if it is in a different place today than in the past.

in association with Templeton Emerging Markets Investment Trust 11 March 2022

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Inflation

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Will inflation prove a problem for emerging markets?

Inflation has become a major economic issue as the global economy tries to return to “normal”.

What does this mean for emerging markets?

David Stevenson Investment columnist

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he post-pandemic recovery has resulted in a flood of stories focused on resurgent demand, surging prices and tales of recovery blues. Inevitably, emerging markets have been caught up in this media storm – they are, we are told, facing any number of headwinds: surging food prices, energy prices, a stronger dollar as a result of higher US interest rates and runs on local currencies, not to mention concerns about companies with dollar-denominated debt.

Investors should step back and evaluate these broad-brush assertions. Not all emerging markets are created equal. Take rising energy and food prices.

That’s bad news for countries such as Turkey, which import a lot of both. But it’s great for a country like Brazil, a big exporter of food and energy. Or take concerns about the strengthening dollar and rising US interest rates. Again, some nations with lots of external, dollar-denominated debt are probably girding themselves for a tricky year ahead as interest costs rise, but others are far less worried.

The Economist recently assessed the vulnerability of a range of emerging markets to US monetary policy.

Countries such as the Philippines, India and Brazil have very low levels of external debt, while others – such as South Africa, Thailand and Vietnam – have enough foreign exchange reserves to ride out a sudden currency sell off. More broadly still, large parts of the developing world have spent the last few decades managing their debts, building up reserves and amassing huge current account surpluses. Meanwhile China is quite deliberately trying to build up its internal consumer economy, cut local property debt and crack down on surging local inflation.

None of this is to deny that there are very real concerns. For instance, the recent spike in fertiliser prices (driven in part by rising energy prices) suggests another leg up in global food prices, while a stronger dollar could yet hit emerging market currencies. But even this dismal prospect has a more optimistic side.

Barring another major jump in fuel prices, energy inflation should begin to ease in the next few months and this generally accounts for 5%-10% of consumer price index (CPI) baskets in emerging markets.

“Not all emerging markets are created equal”

fundamentals for the MSCI Emerging Markets index versus the MSCI World index of developed markets.

Note that in aggregate, emerging markets offer a dividend yield of 2.47% versus 1.36% for developed world stocks; while the forward price/earnings (p/e) multiple for emerging markets is now around 12 versus 18 for developed world stocks (and much higher – over 25 – for US equities).

One challenge is that low valuations have increasingly, in recent years at least, become the hallmark of many emerging markets. Chinese markets for instance are unpopular (with Western investors) right now, and much of the domestic market trades at single-digit p/e ratios. Given the tricky geopolitical environment, it’s not easy to see what might spark a rally – but emerging markets are nothing if not unpredictable. India had a tough pandemic, for example, but local equity markets have surged, driving valuations that were already above average even higher as investors wake up to the potential for digitisation Emerging markets look cheap compared to developed ones Div yield

P/E

P/E forward

P/book value

MSCI EM

2.47%

13.68

12.03

1.84

MSCI World

1.36%

21.54

18.27

3.21

and increasing mobile broadband penetration into one of the world’s fastest-growing consumer markets (see page 8). And these are just two of the world’s biggest emerging markets.

But one point still looms large for any investor in the broad sector. According to estimates by the International Monetary Fund, after adjusting for purchasing power parity (PPP - see page 5), emerging market countries will represent around 60% of the global economy within five years. So ignoring them is not an option. The trick is to work out how to access this globally diverse and heterogenous collection of markets in an effective and engaged way.

Inflation can be good for emerging market assets

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Rising inflation is a global problem right now

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Moreover, some analysts reckon that emerging market equities and bonds perform best in periods of high inflation and strong growth. According to analysts at Swiss group Pictet, in “periods since 1950 when global inflation was above 2% and rising, and global GDP growth was above its four-year average, emerging market equities were significant outperformers in a list of 25 major asset classes, generating average annual returns of well above 20%”.

That’s not what you’d guess from current, depressed valuations. The table (above right) looks at key

11 March 2022 MoneyWeek in association with Templeton Emerging Markets Investment Trust

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Technology

The emerging market tech boom When it comes to innovation, emerging markets are not just catching up but leading the way in several areas.

David Prosser Business Columnist

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t is easy to fall into the trap of assuming that it is Western centres of innovation such as Silicon Valley that will drive the technological change of the decades ahead. However, the amount of invention taking place in emerging markets is remarkable. So much so that for investors looking to back the next big thing, the world’s developing economies may prove to be a happier hunting ground than the West.

The Covid-19 pandemic, moreover, is accelerating that phenomenon, encouraging take-up of digital technologies across emerging markets – and concentrating minds on permanent change. The ability of China to adapt to Covid-19, for example, reflects in large part its mature ecommerce and online payments services. Even before the pandemic arrived, Chinese leaders in these areas, from Tencent to Alibaba, set the standards that other markets have followed.

Ecommerce and online payments are thriving

energy likely to take time. One South Korean steel company, for example, is using artificial intelligence to reduce the energy consumption of its blast furnaces.

Others will tackle the climate crisis head on. China, for example, is already the world’s leading solar panel producer and continues to make rapid advances in improving the efficiency of said panels. China is also leading the way on electric vehicles: China’s Changli now makes the cheapest electric car in the world.

From fintech to green-tech

The next generation of these businesses may not be household names (yet), at least beyond their own shores, but investors are already taking note. For example, Hong Kong-listed Kuaishou, which makes its money from live streaming and online marketing, was the second-biggest initial public offering (IPO) anywhere in the world last year, raising $6.2bn. It was followed by South Korean ecommerce specialist Coupang, which took the third spot in last year’s IPO rankings with a $4.6bn flotation.

These are not isolated stories. The growth in digital banking in Europe, for example, is part of a wider fintech boom, but it is the Brazilian neo-bank group Nu Holdings that has led the way on a string of new technologies in banking, attracting investment from Warren Buffett’s Berkshire Hathaway. Similarly, Africa, where access to banking remains difficult, has been right at the heart of mobile payments innovation.

And to return to the emerging markets of Asia, the dominance of the region’s semiconductor businesses (see page 11) has prompted the US government to approve billions of dollars’ worth of spending in the hope that North America might be able to catch up. Companies such as South Korea’s Samsung, for example, are now focusing on how to produce semiconductors that deliver more power while consuming less energy. That will be crucial given the environmental footprint of IT equipment used in areas ranging from streaming services to bitcoin mining.

Paving the way to net zero

On the broader climate change theme, moreover, decarbonisation is another good example of where emerging markets are driving new technologies. With countries such as India (see page 8) now signing up to net-zero carbon emission targets, the race is on to identify technologies that will help them get there.

Some of those technologies will help countries mitigate the effect of fossil fuels, with the switch to renewable

Improving healthcare delivery

“Chinese tech firm Kuaishou was the second biggest IPO in the world last year”

In healthcare, meanwhile, India and China are now among the world’s most important centres for biotechnology, drug development and pharmaceutical manufacturing. Both have played a prominent role in supplying the world with the vaccines needed to combat the Covid-19 crisis. Other emerging markets are also focusing on health, often embracing new technology as a means to deliver better care in countries where resources are scarce. Mexico, for example, has had significant success with telehealth, enabling doctors to monitor patients remotely.

Many of these advances reflect the enormous market opportunity in developing economies, where innovators see huge potential for growth if they can deliver products and services that capture mass adoption. In China, for example, 900 million middle class consumers are now spending more than $22bn a day; in India, the size of the middle class is expected to more than double by 2030.

However, it would be a mistake to focus solely on consumer-facing innovations, with growing numbers of more industrial businesses in emerging markets also working with advanced technologies. From the “internet of things” to artificial intelligence, the demand for these tools in developing economies continues to grow at pace. For all these reasons, funds investing in emerging markets are likely to increase their allocations to technology-focused businesses – as well as businesses enabled by technology – in the years to come. As companies in these markets continue to innovate, and to pioneer new business models, they have the potential to deliver outsized returns.

in association with Templeton Emerging Markets Investment Trust 11 March 2022

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Briefing

11

Taiwan’s high-tech takeover

The semiconductor industry is critical to the global economy. And most of it is concentrated in one emerging market nation – Taiwan. Simon Wilson reports

Because they’re crucial components in ever more of the electronic devices essential to modern life. Semiconductors (or “chips”) are needed in TVs, smartphones, PCs and videogames. But they are also vital to the modern automotive industry, used in everything from in-car infotainment systems to rearview cameras. A typical electric car, which uses chips in its power system, contains about 3,000 different chips. Indeed, the initial cause of the semiconductor supply crunch that shook the world in 2020 – and is still being felt in some sectors – was the sharp fall in global demand for cars at the start of the pandemic. When demand bounced back in the second half of 2020, automakers had to compete with the manufacturers of all the new TVs and games consoles that stuck-athome consumers had been splurging on to get through Covid-19 boredom.

So what happened?

Overbooked chipmakers couldn’t raise production fast enough to meet global demand, resulting in a supply crunch that shut down car production lines around the world. The crunch, which saw the prices of some second-hand cars surge higher than new ones, was one of the most highprofile demonstrations to date of the chip industry’s growing importance. As the electronics sector continues to expand – for example, as artificial intelligence develops, and ever more industrial machines are fitted with sensors – analysts expect more of the turbulence associated with fast growth and tight supply. Last year, chip sales surged 26.2% to a new high of $556bn and 1.15 trillion units (according to February 2022 figures from the Semiconductor Industry Association). Projected sales growth this year is a steadier 8.8%, as makers struggle to ramp up capacity to meet demand.

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Why do semiconductors matter?

Semiconductors are vital to the functioning of the modern world

Which countries dominate?

For such a strategically vital sector, the production of the most advanced chips is highly concentrated in one place, Taiwan, and indeed in one firm, the Taiwan Semiconductor Manufacturing Company (TSMC). Taiwanese fabrication facilities (“fabs”) account for more than half the global market, and 92% of the most advanced and smallest chips – those supplied to the likes of Apple and Alibaba.

TSMC is the first foundry to provide 7nm (nanometre – a billionth of a metre) then 5nm production capabilities, and is investing in 3nm capacity (the size refers to the line width between transistors).

How did Taiwan manage this?

This dominance is relatively new: as recently as 2009, Intel had 100% of the market for the then-leading-edge node, at 45nm. Taiwan’s dominance is due to three key factors. First, “A typical electric car intensive state-backed What exactly is a investment since semiconductor? contains about 3,000 the 1970s (in close In materials science, different chips” collaboration with the a semiconductor is US) and the creation of TSMC in the 1980s. simply a material which is neither a Second, TSMC’s partnership with Apple, good conductor of electricity (like copper), beginning in 2011, which pushed its frontier nor an “insulator” (like glass). This technologies and commercial clout ever property of being somewhere in the middle further. Third, making the most advanced is useful in the building of electronic chips has become extremely difficult and circuits, because small changes to a capital-intensive, requiring huge investment semiconductor can result in big changes to and years to scale up production, so there conductivity. That helps engineers to build diodes (an electronic “turnstile” conducting are considerable disincentives for other nations to try to play catch up. current in only one direction), transistors and ultimately a silicon chip, a small piece of silicon holding thousands – or nowadays Who is trying to catch up? tens of millions, and even billions – of South Korea, the nearest rival, has about infinitesimally tiny transistors. Today, 17% of the market. It has committed the term “semiconductor” (the material $450bn to chip investment by 2030, with component) is used interchangeably with most coming from private companies “chip” (the end product). including market leader, Samsung. The US, moneyweek.com

despite being a decades-long leader in chip design and research, has only around a 10% slice of manufacturing, the same as Europe.

China has set a target of meeting 70% of its chip needs domestically (currently it’s just 16%, according to IC Insights). Its biggest player, the Semiconductor Manufacturing International Corporation (SMIC), has ramped up investment and tried to make the leap into ever-smaller chips. Meanwhile in Asia, Europe and the US, pandemic disruption, as well as geopolitical concerns over the potential threat to Taiwan from Beijing, have pushed national governments to look again at their reliance on TSMC.

What are they doing?

Treating semiconductors as a strategic priority. At the end of January the planned acquisition of German chip supplier Siltronic

by Taiwan’s GlobalWafers collapsed when it failed to get approval from Berlin. In the US, Intel is investing $20bn in two giant chip factories in Ohio, while the Biden administration is seeking Congressional support for its Chips for America Act, a $52bn package of subsidies to promote US semiconductor firms. The EU has announced a €43bn investment and state subsidy plan aimed at doubling Europe’s share of the semiconductor market from 10% to 20% by 2030. Currently, Europe has significant strengths in corners of the semiconductor supply chain (for example in the aerospace and industrial automation sectors). But it lags a long way behind east Asia when it comes to making the most advanced chips for high-end computers, phones and other devices. One thing is sure: Taiwan is not going to give up its preeminence without a fight. TSMC recently announced a rise in capital expenditure this year to as much as $44bn. That’s a threefold jump in the past three years.

11 March 2022 MoneyWeek in association with Templeton Emerging Markets Investment Trust

Emerging Markets tech trends and more in 2022 and beyond

T

he discovery of the Covid-19 Omicron variant has generated economic uncertainty and market volatility. At the time of writing, it remains too early to draw conclusions about the pandemic’s path ahead, and we are monitoring the situation closely. What we know is this: much of the world is learning to live with Covid-19 as vaccination rates climb and new treatments arrive. Even as new variants delay the return of pre-pandemic normalcy, the worst market fears should be behind us. We expect pandemic worries to recede gradually and unevenly.

This should help bring the structural growth drivers in emerging markets back into investors’ view.

Tech-tonic shift

We view resilient technology demand as a multiyear tailwind for emerging markets.

The pandemic has given digitalisation a permanent uplift, even as economies continue to normalise. The consumer

internet industry has so far led the way in digital transformation, though we have also begun to see industrial internet applications take off as manufacturers tap innovation to raise productivity. A growing appetite for industrial internet solutions points to more technology spending ahead.

The overall internet landscape across emerging markets remains dynamic and diverse. China has served as a massive laboratory, pioneering business models in e-commerce, online payment and other services that other markets have subsequently adopted and adapted to succeed in their own right. In South Korea, for example, a leading internet search company is also one of the largest e-commerce players in the country. Many internet businesses have also just started to list publicly in markets such as Southeast Asia and India. As a whole, internet businesses have become allpervasive and still have significant scope for growth across emerging markets.

As the number of internet companies

multiply, so will competition. We are mindful of this and favour companies that can sustain their competitive advantages. We are also on the lookout for the next big innovations. China, South Korea, Taiwan and other markets with deep technology capabilities appear wellpositioned to drive the next wave of breakthroughs.

Semiconductors form the backbone of technological progress and we expect demand for them to stay strong, which should benefit world-leading semiconductor companies in South Korea and Taiwan. An additional demand boost could come from longer-term developments in the metaverse.

Meanwhile, sustained software needs should buoy prospects for technology services providers. Across emerging markets, cloud solutions are in a nascent stage of growth and we think there is room for their penetration rate to catch up with that in the Western world.

Decarbonization drive

We see technology playing a critical role in another secular trend—the pursuit of net-zero carbon emissions in emerging markets. Advanced semiconductors hold

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Resilient technology demand will represent a multiyear tailwind for emerging markets, as pandemic fears recede gradually and unevenly across the globe the key for building better-performing hardware that consume less power.

Consumer and industrial internet applications have also helped to optimise supply chains, streamline logistics and drive other efficiencies that reduce carbon footprints.

Many carbon-intensive companies anticipate higher carbon costs and are actively employing technology to cut their emissions. For instance, a steel company in South Korea has developed artificial intelligence to monitor and optimise the operation of blast furnaces, which can pare its energy consumption.

We believe there can be investment opportunities in high-emission companies that have the commitment and technological tools to decarbonise as they would be able to survive the higher carbon costs in the future.

Emerging markets have also accelerated their push for electrification and renewable energy. Electric vehicle (EV) adoption could quicken, which supports our optimism toward companies in the EV value chain. We are also positive on world-leading solar energy companies in emerging markets.

Addressing market concerns

We view technology and decarbonisation as long-term investment themes in China, although its zero-Covid-19 policy and recurring lockdowns could hamstring its near-term growth. Regulatory changes in China have also led to a reset in the market’s growth expectations for some of its largest internet companies. That said, we believe that valuations have adequately reflected this reset.

Stock valuations in Brazil have shrunk amid rising interest rates, fiscal concerns and political uncertainty ahead of next year’s general elections. We find Brazil’s stock market undervalued. We view Brazil as a Covid-19 recovery play and its

Chetan Sehgal, CFA Lead Portfolio Manager, Templeton Emerging Markets Investment Trust

Andrew Ness Portfolio Manager, Templeton Emerging Markets Investment Trust economic growth could surprise on the upside, aided by efficiencies arising from a thriving internet economy.

Inflation has dominated market concerns amid supply chain disruptions, pent-up demand and the commodity upswing. We see the potential for supply chain bottlenecks to ease as Covid-19 restrictions gradually loosen. Demand should also normalize, which is likely to reduce support for commodity prices.

Considering these factors, we don’t view inflation as a longer-term concern for emerging markets.

A sustainable story

Emerging markets are a long-term story of evolution and progress. Amid various changes, what we ultimately seek are companies with sustainable earnings power, trading at valuations we find attractive. A key feature that we look for are management teams with the flexibility to adapt to shifting business conditions. Companies with strong and enduring competitive advantages also stand out to us. We believe that our investment approach is a durable strategy for capturing opportunities in emerging markets regardless of market cycles.

For more information, please visit www.temit.co.uk

Important Information This material is intended to be of general interest only and does not constitute legal or tax advice nor is it an offer for shares or invitation to apply for shares of the Templeton Emerging Markets Investment Trust (TEMIT).

Nothing in this article should be construed as investment advice.

Opinions expressed are the author's at publication date and they are subject to change without prior notice. The value of shares in TEMIT and income received from it can go down as well as up, and investors may not get back the full amount invested.

Past performance is not an indicator or a guarantee of future performance. Currency fluctuations may affect the value of overseas investments. When investing in a portfolio denominated in a foreign currency, your performance may also be affected by currency fluctuations. In emerging markets, the risks can be greater than in developed markets.

Any research and analysis contained in this article has been procured by Franklin Templeton Investments for its own purposes and is provided to you only incidentally. References to particular industries, sectors or companies are for general information and are not necessarily indicative of TEMIT's holding at any one time.

Shares of the TEMIT are available for sale and distribution in the UK. There is no guarantee that TEMIT will achieve its objective.

Please consult your financial adviser before deciding to invest.

An investment in TEMIT entails risks which are described in the TEMIT annual report and TEMIT Investor Disclosure document which can be downloaded from from www. temit.co.uk or request one, free of charge, from Franklin Templeton Investment Management Limited, Cannon Place, 78 Cannon Street, London EC4N 6HL. Authorised and regulated by the Financial Conduct Authority.

Telephone: 0800 305 306, Email: enquiries@ franklintempleton.co.uk.

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14

Funds

Why it pays to go active in emerging markets When it comes to investing in emerging markets, there are reasons to favour active management over passive options

ne key decision investors have to make when they approach a new market or sector is whether to invest using a passive or active fund. Passive investing has several attractions. Unlike their actively-managed peers, passive funds simply track an underlying index or benchmark. You won’t beat the underlying index but nor will you underperform (excluding costs).

Passive funds are also cheaper than active funds. If you combine these two factors with the fact that many active managers in developed markets struggle to beat their benchmarks, it’s easy to see why passive investing has become so popular over the past few decades.

However, when it comes to emerging markets, passive may not automatically be the best choice. An interesting piece of research produced by US asset manager Putnam Investments last year suggested that emerging market equities are one area where active management can still add significant value. Putnam compared returns on the top passive strategies with those for low-cost active funds for the ten years to the end of November 2020. Passive won easily across all of the US-focused active strategies, but in emerging markets, the active funds beat the passive ones by an average of nearly two percentage points a year.

“Emerging markets may offer more opportunities for genuinely active managers”

The case for investment trusts

Inefficient markets and state-owned stocks

So what makes the difference? One factor is that emerging markets are generally viewed as less “efficient” than developed markets. An “efficient” market is one in which all new information is absorbed by market participants so comprehensively that outperformance is in effect impossible, because there is no scope for investors to have an “edge”. The argument here is that the S&P 500, for example, is so thoroughly pored over by analysts and investors that there are no hidden pockets of mispricing to exploit.

Emerging markets by contrast are less closely followed and thus present more opportunities.

The extent to which this market efficiency point is a genuine issue can be debated, but it’s certainly the case that emerging market indices tend to be far less representative of the underlying asset class than is the case for developed markets. As David Stevenson points out on page 4, emerging markets cover such a wide range of markets and sectors that it’s almost inevitable that the benchmark indices – the ones typically used by passive funds – will be skewed heavily towards bigger countries or sectors. This gives active managers more scope to outperform the benchmarks by investing in markets or sectors which are underrepresented in these indices.

Putnam also notes that benchmark indices tend to have a heavier weighting towards state-owned enterprises (SOEs) which are not necessarily run with shareholder value in mind. This is another area where active managers can make a difference. Governance has always been critical in emerging markets, given that many of the institutions taken for granted in developed markets are at earlier stages of evolution.

But the increasing attention paid to investing with environmental, social and governance (ESG) factors in mind means this issue has become even more

important, particularly as levels of ESG disclosure vary so drastically across emerging markets. An active manager is better placed to be selective and to choose the highest-quality stocks, and to gauge which companies are making progress and considering their obligations to stakeholders (as well as shareholders) and which should be avoided. This is another potential source of market inefficiency, and thus “alpha” for active investors. Moreover, if you accept the argument that companies with strong ESG credentials are also more likely to demonstrate greater transparency, accountability and willingness to engage with shareholders, then this can only be beneficial for emerging market investors in general.

Hunting for an edge

As for which active vehicle to choose, investment trusts are particularly well suited to emerging markets.

Managers of investment trusts are dealing with a permanent pool of capital (ie when investors want to exit the fund, they sell shares to another investor, rather than potentially forcing the manager to raise cash by selling holdings in the portfolio). This can result in trusts trading at a discount to the value of their underlying portfolio (because the shares trade independently of the net asset value). However it also means that managers have more scope to invest in less liquid assets and with a longer time horizon in mind, which can be a particular advantage when dealing with less well-developed markets.

Investment trusts also have the ability to use an element of gearing – borrowed money – to invest with more conviction when they feel the opportunity is ripe, potentially boosting returns (though of course, gearing cuts both ways if a manager’s conviction is ill-timed).

Investment trusts are listed on the stock exchange, can be held in an individual savings account (Isa), and can be bought via your investment platform – just be sure you are aware of any broker charges.

in association with Templeton Emerging Markets Investment Trust 11 March 2022

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• 30+ year track record • Over 1 billion shares in issue • ‘Low carbon’ designation† from Morningstar®

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