If the world deglobalizes, how should investors adjust their portfolios?

Emerging markets equities offer attractive, investible, long-term themes

01 May 2019

Geoffrey Wong, Head of Emerging Markets and Asia Pacific Equities, took the stage at the Sovereign Investment Circle in Singapore and presented his views on prospects for Emerging Markets (EM) in a deglobalizing world.

Key takeaways:

  • Globalization has moved in steps but the contribution of trade to global GDP may not increase further from current levels;
  • Old definitions of globalization are past their prime and the key trend to look out for is the rise of domestic demand in Emerging Markets;
  • Within the domestic demand trend, investors can find long-term investible themes in EM like the growth of after-school tutoring, premium brands, R&D and innovation, and financial services.

Globalization has moved in steps

Wong began by showing how globalization has progressed in steps over the years.
The first step occurred during the 1960s and 1970s as factories moved into 'Tiger Economies,' like Malaysia, Thailand, Philippines, Indonesia and Singapore, and trade as a share of global GDP rose rapidly1.
The next step began in the early 1990s with the opening of China, followed by an acceleration in trade as a share of global GDP as manufacturers shifted to China and it entered the WTO in 20012.

Trade as % of World GDP

Source: UBS Asset Management, FactSet, 29 September 2018

Wong went on to argue that trade's contribution to world GDP may not increase further from current levels because the forces driving the above steps may have run their course.

That's because, firstly, manufacturers keen on setting up in China have largely already done so and, secondly, because manufacturers are now reconfiguring their supply chains rather than expanding them.

For example, many firms are now relocating from China to Bangladesh or Vietnam. While that sounds like expansion, it’s actually a substitution of capacity in one location for another, which is likely not sufficient to boost globalization as measured by trade as a percentage of GDP.

EM are now driving global GDP

Wong showed that a more significant trend lies within EM and in the ongoing transition from producing for overseas markets to producing for domestic markets.

These headline macro trends are changing the way that EM companies earn their revenues.
For example, companies in the MSCI EM index now derive 71% of their revenues from either their home countries or from other EM countries, and 93% of revenue for companies in the MSCI China index comes from China3.

As such, when investors buy an EM portfolio they are buying companies that are primarily targeting their local markets and are increasingly in domestic demand-related sectors, like consumer and IT, which have taken market share in EM indices away from energy, materials, industrials and telecoms sectors.
These trends are being driven by fundamental changes in the global economy that are putting EM countries in the driving seat.
For example, EM will contribute 62% of global economic growth, far exceeding the combined 25.8% contribution from the US and Euro area4 in the next five years.
More specifically, the population of working age people in EM will grow 0.81%, on average, per year between 2019 and 2050, while it will decline 0.3% per year in developed markets5. That demographic change is significant because it means that the world's new working population and consumer bases will come from EM and support domestic demand growth.

EM offer interesting investment opportunities

Going further, Wong highlighted interesting growth stories within the domestic demand trend in EM, and focused on demand for after-school tutoring, the shift to premium brands, R&D and innovation, and financial services.

  • After-school tutoring: China is a huge market, but highly fragmented, and Wong believes larger players have the opportunity to add market share. Principally, that's because larger firms are better resourced but, specifically, they have a (growing) technological advantage over competitors because they invest heavily in IT. In practice, these companies offer innovative in-class monitoring to both report on students' progress and refine the courses to suit the students' needs.
  • Premiumization: As incomes and the number of better-off households rise in EM, consumers are trading up for better quality brands and premium goods. An excellent example of this trend lies in baijiu (white liquor) in China, where we are seeing sustained strong demand for premium segments of the market6. Additionally, other consumer products like beer and clothing are benefiting from growing demand for premium goods.
  • R&D and Innovation: EM are producing more leading companies because firms in the region are ramping up R&D spending7 and becoming more innovative, with a case in point being how China overtook Japan as the 2nd largest source of international patent applications in 20178. One further example of this trend is a Chinese security camera company which, using AI-driven facial recognition technology, has recently grown into one of the world's leading camera companies.
  • Financial services: Generally speaking, EM countries, particularly Indonesia, Peru, and Mexico, have lower credit penetration and are 'unbanked' compared with more developed markets9. Wong believes that the banking sector in these countries offer interesting opportunities as they catch up to reach levels of credit penetration seen in more developed countries.

Baijiu sales by segment, estimated volume growth CAGR, 2020 (f) vs. 2016

Source: UBS Asset Management, October 2018

In summary, Wong said that there is uncertainty surrounding globalization, global trade and the impact of US-China relationship

However, investors can find many investment opportunities in EM, particularly as intra-EM demand grows and themes like premiumisation and growth of financial services play out.

Furthermore, these opportunities have a long way to run because the fundamental forces underpinning them are robust and long-term in nature.


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