A bucketful of opportunity

Legendary investor Warren Buffett shared this pearl of wisdom for investors: “Opportunities come infrequently. When it rains gold, put out the bucket, not the thimble." As far as emerging markets are concerned, a thimble seems as apt a description as any, with allocation estimates settling around 5-10% for a typical retail investor portfolio.

To put this into some context, the chart below illustrates the global share of emerging markets across various criteria. It’s certainly a large universe, with the International Monetary Fund (IMF) categorising almost 100 countries as ‘emerging market and middle-income economies’ (more than double the number of advanced economies).  Emerging markets are also starting to dominate by GDP, a trend that’s likely to continue given they’re home to 85% of the world’s population.

With this in mind, are investors missing a trick in their allocations to emerging markets? The answer is quite possibly: raining gold may verge on the hyperbolic but Goldman Sachs forecasts that the value of emerging markets will exceed the US stock market by 2030 and account for the lion’s share of global equities by 2075, fuelled by favourable demographics and strong economic growth.

The drivers of economic growth

Frontier markets are at an earlier stage of economic development and, as a result, are forecast to have higher GDP growth rates than their developed counterparts. BlackRock Frontiers (BRFI) aims to capitalise on this superior growth potential by investing across the broad universe of emerging markets, excluding the previously eight largest countries (Brazil, China, India, Korea, Mexico, Russia, South Africa and Taiwan).

The chart below shows forecast annual GDP growth for the five largest country allocations in the BRFI portfolio (as at 31/05/2024), which are among the highest globally. Notably, the Philippines and Indonesia have forecast growth of more than 5%, substantially above the 2% growth rate for the UK and EU.

One of the recent drivers of economic growth is ‘friend-shoring’ due to growing trade tensions between the US, and, on the other side, China and Russia. This has created an opportunity for ‘neutral’ countries to attract capital and trade from both blocs as countries and companies look to safeguard supply chains.

Indonesia is one such example, being the largest global producer of nickel and the second-largest producer of cobalt, both critical minerals in the transition to net-zero. Indonesia is one of the primary exporters of nickel to the Chinese electrical vehicle industry and is also in discussions with the US to create a free trade agreement to supply US car manufacturers. This demonstrates the country’s ability to build strong relationships with both the East and West and benefit from strong secular growth drivers (such as the move to clean energy).

Looking at Indonesia more widely, it is currently the 16th largest economy globally (by GDP), with a large working-age population, burgeoning middle class and substantial natural resources. The government has demonstrated strong economic leadership, with a forward-looking industrial strategy encompassing structural reforms to attract foreign investment and the signing of free trade agreements. As a result, Indonesia has successfully established itself as a “China plus one” destination for multinational companies.

Indonesia is currently the second-highest weighting in BRFI’s portfolio (second only to Saudi Arabia), as the managers believe that the increase in nickel exports, and the associated reduction in the current account deficit, should stimulate further foreign investment and economic growth. BRFI’s largest holding (as at 30/06/2024) is currently the Bank Central Asia which has delivered strong returns from its market-leading position in the Indonesian commercial banking sector.

Strong macroeconomic fundamentals

Macroeconomic conditions are a key driver of returns in emerging markets, but with success shaped as much by the internal and specific dynamics of domestic economies than the wider global economy. With that in mind, the BlackRock Emerging Markets Team maintains a ‘macro dashboard’ which scores countries based on interest rates, economic activity and debt levels (amongst other criteria) to understand where a market is in its economic cycle, and whether changing conditions may be supportive or conversely act as a headwind to company returns.

While Europe and the US have struggled to control sticky inflation, the fiscal and monetary policies of many countries in BRFI’s universe have created a tailwind for equities. These countries were quicker to raise interest rates and, as a result, are ahead of their western counterparts in their readiness and ability to meaningfully ease conditions. Interest rate cuts have already been instigated by Chile and Hungary and, looking ahead, falling rates should provide a supportive domestic backdrop.

BRFI has also started to increase its exposure to a number of smaller markets, including Pakistan, Egypt, Kenya and Nigeria, due to their improving macroeconomic fundamentals and the potential for alpha generation. Currency devaluation can also provide an economic boost by reducing current account deficits and helping to attract foreign investment, with Egypt recently implementing a 40% devaluation of its currency to secure a generous loan package from the IMF.

Why it pays to be selective

There are high barriers to entry for retail investors in emerging markets due to a lack of information and the challenge of understanding a wide range of different economic and political environments. This is a sector where on-the-ground resources are critical to provide in-depth knowledge of the large investable universe.

Managers Sam Vecht, Emily Fletcher and Sudaif Niaz have extensive experience in investing in emerging markets, and are supported by the substantial resources of the BlackRock Emerging Markets Team.

The team conducts a regular series of trips, including Egypt, Kenya, Nigeria, Pakistan, Kuwait and the UAE in recent months. Meetings with companies, local officials, suppliers and competitors allow the managers to build a first-hand insight into a company’s potential investment attributes.

One strong performer in the BRFI portfolio is Eldorado Gold, which is a Canadian-listed gold mining company that generates a substantial proportion of revenue from high-quality assets in Turkey and Greece (in addition to Canada). Eldorado has enjoyed a share price increase of almost 50% over the last year (as at 25/07/2024) and plans to commence copper production in 2025, tapping into the strong forecast growth for copper in the upgrade of network infrastructure in the net-zero transition.

The quality of the managers’ stock-picking skills is reflected in BRFI’s impressive track record. The trust has achieved a five-year net asset value total return of 39% (as at 24/07/2024), more than double its benchmark and significantly above the 14% return of the MSCI Emerging Markets Index (in GBP).

While the trust’s main objective is capital appreciation, it’s also worth noting that BRFI is the highest-yielding trust in the AIC Global Emerging Markets sector, with a current dividend yield of 4.5% (as at 24/07/2024). Many portfolio companies are strongly cash-generative, and due to limited opportunities for reinvestment on occasions, dividends are an important contributor to total returns.

Investors should be cognisant of the higher inherent risks and the benefit of taking a longer-term view in emerging markets. That said, investors heeding Buffett’s advice to upgrade to a larger receptacle may well reap the rewards if emerging markets live up to their potential.

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