A New Generation of Emerging Markets Is Poised to Rise

The EM golden era was the confluence of perfectly timed factors including structural tailwinds and inefficient capital markets supported by a conducive external environment. All are unlikely to be replicated. Furthermore, the benchmark-aware investment style of active EM funds is inconsistent with the structural pivot in emerging markets. Those funds have a strong allocation bias toward the global emerging markets, or GEMS, made up of Brazil, Russia, India, China, and South Africa in the BRICS along with South Korea and Taiwan.

The EM investment story in the early 2000s was premised on the GEMs’ ability to revolutionize global supply chains by reducing manufacturing costs. They also had an enticing story of evolving consumption, focused on 2.8 billion people in the world’s fastest growing economies. These factors, combined with a slowdown in developed markets at the time, made this a lucrative investment proposition. But that has all changed over the last decade. 

The economic growth delta between emerging and developed markets has since narrowed. A combination of base effects and rising economic linkages have made the GEMs increasingly susceptible to global demand dynamics. Similarly, the demographic dividend was a hallmark of the golden era. But it has now plateaued in most EMs (except for India). The over-55 age group in China, South Korea, and Taiwan will account for 40-49% of the total population by 2040. Finally, elevated risk levels due to economic policy mishaps (South Africa and Brazil) and geopolitical tensions (China) have soured global investor appetite as seen in the volatility in foreign inflows. 

Three factors drew equity investors to the GEMs initially: first, low correlation to developed markets, second, inefficient capital markets with high information asymmetries dominated by unsophisticated local investors, and third, negligible levels of foreign ownership Those were ideal alpha-generation attributes that also achieved the golden tenet of portfolio diversification. But too has changed over the last decade.  

In addition to increased correlation to developed markets, the information asymmetries have significantly converged. In fact, there are more analysts covering Tencent (78) and Ali Baba (70) than Amazon (68) and Microsoft (67) today. This is increasingly problematic for alpha generation considering active EM managers tend to mirror the benchmark country and security allocation. Data from Copley Research on the 10-year performance of active EM equity funds, representing $365 billion in assets under management, supports our assertion. Those funds have delivered a mere 275 basis points of cumulative alpha, with returns indistinguishable when comparing across active share levels.  

Those factors contribute to a dour outlook for EMs. But there are identifiable traits reminiscent of the golden era in what we call the next generation of global emerging markets, or Next GEMs. This group which broadly consists of the ASEAN-5 (Philippines, Indonesia, Malaysia, Thailand, Vietnam) and the Gulf Cooperation Council bloc (Saudi Arabia, the United Arab Emirates, Kuwait, and Qatar), has largely evaded the radars of mainstream investors given low EM index representation and dearth of dedicated research coverage. They are well-positioned to benefit from global supply chain realignment, domestic reforms (particularly in the GCC), and sustainable consumption. 

The ASEAN-5 are key beneficiaries of supply chains relocating away from China, with a powerful tailwind stemming from the global electric vehicle and semiconductor supply chains. Indonesia and Philippines have a strong advantage in the EV value chain as they are among the top five countries in terms of global nickel and cobalt reserves. Similarly, both Indonesia and Thailand are the largest automotive production centers in Southeast Asia with critical infrastructure in place to seamlessly integrate into the EV value chain. Meanwhile, the GCC is undergoing a powerful structural shift with reforms aimed at diversifying away from oil production with a $1 trillion infrastructure outlay, among others. Finally, the next GEMs will be key drivers of increased global renewable energy and EV adoption.  

These themes will generate a powerful ripple effect on overall domestic consumption. In the case of the GCC reforms, rising fiscal spending and a growing expatriate population will positively impact the healthcare, education, and real estate sectors. The relocation of the EV supply chain to the ASEAN-5 should stimulate domestic employment, discretionary spending, and the lending activities of local financial institutions. In this regard, Indonesia is an exciting story and is expected to overtake Brazil as the world’s fourth largest consumer market by 2030. 

For equity investors, in addition to those structural tailwinds, the next GEMs offer low correlation to developed markets and are significantly underresearched, making them ideal for generating diversified uncorrelated returns. Furthermore, increased domestic investor participation and robust initial public offering activity has led to a significant liquidity surge in these markets. For instance, Saudi Arabia and Thailand have already surpassed the 2015 daily liquidity levels of Brazil and South Africa.    

Capitalizing effectively on the Next GEMs requires a distinct investment approach. The traditional, benchmark-aware strategy of active EM funds is inconsistent with the structural pivot within emerging markets. Instead, a benchmark-agnostic fund approach that encapsulates the various Next GEMs can maximize diversification while balancing liquidity. Doing this can position investors to benefit from the unique opportunities offered by these markets, while mitigating risks associated with investing in EMs. The evolution of EM equities calls for a fresh perspective and a willingness to explore the untapped potential of the Next GEMs.   

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