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Economies such as Brazil and India with more domestic demand are better placed to weather a more challenging environment, says an expert.VANDERLEI ALMEIDA

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With financial markets currently dealing with so much uncertainty, it may not seem like the ideal time to consider investing in emerging markets. After all, these smaller, developing markets are generally considered the riskiest and most volatile with the greatest potential for unexpected negative surprises.

Despite these factors, there are good reasons for investors to consider devoting some of their portfolios to emerging markets.

Although 2022 was a challenging year for emerging market investors, it was not all doom and gloom,” says Andrew Ness, portfolio manager at Franklin Templeton Investments in Edinburgh, U.K., who manages Templeton Emerging Markets Fund for Canadians.

He notes that emerging markets found support from a combination of events late last year, leading the asset class to end the final quarter of 2022 with positive returns. Looking ahead, Mr. Ness is optimistic about the asset class supported by China’s pivot away from zero-COVID-19, an easing of global inflationary pressures and prospects for a recovery in earnings growth in 2023.

Lower inflation, however, can also be associated with a weakening global outlook. As a result, he feels economies such as India and Brazil, with more domestic demand, are better placed to weather a more challenging environment.

Mr. Ness says that as the investment environment evolves, an important feature that his firm seeks in emerging markets is resilience in terms of both economies and companies.

“A particular area of focus for us is the sustainability of corporate earnings, whether in the face of COVID-19, policy changes, technology disruption or other challenges,” he says.

“We seek companies with structural growth drivers aligned with digitalization, decarbonization and premiumization emerging as long-term winners.”

As far as regions and countries go, Mr. Ness notes his group’s investment approach is bottom-up. So, rather than reflecting a country view, its portfolio positioning is the result of specific opportunities they have identified in each country. Currently, its largest country overweighting compared to the benchmark index is South Korea, where they are attracted by semiconductor companies and companies related to the electric-vehicle (EV) battery supply chain.

The group is underweight in China, but it remains the largest single-country exposure within its portfolio.

One of Franklin Templeton’s top 10 emerging market holdings is LG Corp., a large South Korean conglomerate. Mr. Ness notes the company trades at a substantial discount to its net asset value and highlights its LG Energy Solution unit, which is the No. 2 producer of lithium-ion batteries, a key component used in EVs.

Focus on company fundamentals

“Last year’s headwinds for emerging markets look primed to become tailwinds in 2023,” says Philip Ehrmann, senior portfolio manager at Manulife Investment Management Ltd. in London, U.K., and co-manager of Manulife Emerging Markets Fund.

Mr. Ehrmann notes that with compressed valuations, peaking inflation in many emerging market countries, and the potential for interest rate cuts, the ingredients for early stages of recovery are present. Despite that optimism, his group “doesn’t expect the sailing to be smooth ahead,” especially considering geopolitical issues.

Mr. Ehrmann says that although the macroeconomic environment has changed materially over the past year, his firm remains focused on company fundamentals.

“We are quality growth managers, focused on best-in-class, high-return companies with sustainable competitive advantages at attractive valuations,” he says. Portfolios are constructed on an active bottom-up basis, calibrating growth potential, diversification and risk control.

China is a market Manulife’s emerging markets group continues to be constructive on.

“With low valuations and an improving macro and earnings outlook, China is a market where we can see asymmetric returns in 2023,” Mr. Ehrmann says.

He also notes that members of his investment team visited Taiwan, Korea, and India, where they saw evidence of surging economic demand. Conversely, the firm is generally cautious on investment opportunities in Saudi Arabia and certain segments in Taiwan. Mr. Ehrmann notes Saudi Arabia is an expensive market, boosted by the commodity energy price increase in 2022.

Longer-term growth opportunities

Christine Tan, portfolio manager at SLGI Asset Management Inc. in Toronto, says her firm is very excited about the growth opportunities in emerging markets. Her firm offers three emerging market funds under the Sun Life Global Investments banner. She notes Sun Life’s decision to have a permanent strategic allocation is based on its view that emerging markets provide longer-term growth opportunities above that of developed countries.

Emerging market equities and fixed income also offer diversification benefits, while emerging markets fixed income provides a higher yield. While the return potential is higher, SLGI recognizes higher political risk, different levels of corporate governance, and significant regulatory/policy changes are not unusual in fast-growing economies. She also notes research coverage of emerging market companies are also not as extensive as in developed economies

“We came into 2023 cautiously optimistic about the outlook for emerging markets,” Ms. Tan says. One factor she cites is China ending its zero-COVID-19 policy at the end of 2022 – and its benefit to the economies of China and other emerging market economies.

“Emerging markets have underperformed U.S., Canadian and European equities since 2020 and are trading at a more attractive valuation,” she notes.

On the other hand, she notes higher U.S. interest rates mean a stronger U.S. dollar, which is a problematic headwind for emerging market assets.

When it comes to regions and countries, Ms. Tan says Sun Life’s emerging market subadvisor currently likes South Korea and Brazil. She notes that although South Korea is a trade-oriented economy that will be affected by slowing global growth, valuations and the currency are inexpensive.

She says there’s political noise around Brazil but the manager sees attractive valuations in financials and certain commodity producers. The two countries the manager is cautious about, primarily due to rich valuations, are Saudi Arabia and India.

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