The backdrop for emerging market investors this year has been tricky, to say the least. There have been several headwinds to grapple with, chief among them the question of inflation that has been on everyone's minds. We still believe inflation will be transitory. The real question, of course, is how long is ‘transitory’? There have been shocks to both supply and demand over the past two years that are almost without precedent and caused to a large extent by logistics bottlenecks and government policy, both of which are expected to normalise within the next 3-6 months. We continue to believe the longer-term deflationary trends are more powerful and structurally persistent: demographics, debt and technology disruption are likely causing there to be longer-term low levels of inflation.
We believe that in the shorter term, the taper effect will be manageable. It will have an impact, but we invest in quality, resilient companies that have pricing power, and therefore reprice in line with changes in inflation.
Another key issue being talked about is the shift from growth to value that for a quality growth portfolio such as ours has clearly presented a challenge. The chart below shows how extreme and how distorted valuations of high growth, high ROIC companies have become, particularly in the context of Asia – these companies are now trading at two standard deviations below their long-term averages versus global peers, which looks very extended and an excellent entry point to quality, long-term franchises, in our opinion.
Dollar strength has clearly been a headwind, but that is something we are used to living with in emerging markets. We fully understand that will happen at times, and we aim to generate strong returns regardless. The real story – and one that has picked up hugely of late, as you can see from the chart below – is China.
The Chinese Communist Party has just celebrated its first centenary and as it looks forward to the next 100 years, the challenges are very different. To maintain its legitimacy for the next 50 years, the Party realised it is critical to lift the 600 million people left behind, the low-income families, into higher income brackets. As a result, its priority has shifted from a singular pursuit of growth and efficiency to one that balances growth with sustainability and efficiency with equality.
The key word here is ‘balance’. There are concerns whether that would mean much lower structural growth and how the private sector – that provides more than 87% of urban employment – will continue to play an important role. To lift this many people out of poverty and move them up the income ladder, still requires a great deal of growth, investment, innovation and, most importantly jobs, good jobs. This cannot be achieved without a dynamic and vibrant private sector. If successful, it will unleash huge consumption power that is likely to completely transform China's consumer market, creating many interesting opportunities in the process, particularly in areas such as dental care and leisure.
[China's] business model is built on empowering millions of smaller merchants to do business more easily in the digital age as well as enabling hundreds of millions of consumers to live better and make better decisions.
China is also facing similar challenges to many other countries – inequality, climate change and how to regulate big tech. Another consideration is whether/how China's big tech platforms will survive and thrive. Their business model is built on empowering millions of smaller merchants to do business more easily in the digital age as well as enabling hundreds of millions of consumers to live better and make better decisions. We believe having better regulation in place will not materially change the long-term sustainable earnings power, in most cases.
China equity had a 20%+ pullback during the recent regulatory reset, yet we remain positive and think four mega trends are going to drive growth and performance: digital leaders, middle-class consumers, ageing China and the rise of the machines (automation and robotics).
Given our remit as emerging market investors, we also see a world of opportunity outside China. India is likely to become more and more powerful as an investment destination over the coming decades. Its share of global consumption in 2020 was 9% and is forecast to rise to 17% by 2030.
Added to that, of the next billion to ascend to the middle class over the coming decade, 50% will come from India. We are also seeing a rise in the broadening and deepening of the Indian stock market, a large number of attractive IPOs coming to market, gaining high investor attention.
We are able to find many attractive companies across the emerging markets, that we manage in our suite of Emerging Market, China and Asian ‘Stars’ funds, using the process we launched when we joined Polar Capital in 2018. All three Funds are managed using the same process which fully integrates sustainability analysis.