Emerging markets: built for the long term

Conflict in the Middle East and the associated rise in energy prices has shaken confidence and seen market volatility increase, but the long-term drivers of emerging market equities remain in place. Here, Chris Tennant, co-portfolio manager of Fidelity Emerging Markets Limited explains why growth in emerging regions is expected to outpace developed markets over the long term. 

Opportunity amid volatility

The situation in the Middle East is evolving rapidly, and it remains unclear how and when the conflict might end. This uncertainty has fed through to equity markets: volatility has risen sharply, with fresh headlines and soundbites meaningfully boosting or eroding investor sentiment. But unless the conflict persists and we see a much more prolonged period of elevated energy prices, the long-term prospects for listed companies in emerging markets should be largely unaffected.

It is worth noting that the direct impact of hostilities in the Middle East on the asset class is low. Companies listed in the Gulf region only account for around 6% of the MSCI Emerging Markets index. Exposure to these countries in our Emerging Markets strategy is currently even lower still, owing to underweight positioning in the region.

More broadly, the spike we have seen in energy prices is affecting energy-importing countries like China and India most acutely. Higher energy prices for consumers and the prospect of shortages for industrial companies is a headwind and helps explain why our Emerging Markets strategy currently has underweight exposure to these two markets. While structurally attractive over the long term, Indian equities remain reasonably expensive in our view, particularly given rising competition in the financial sector and with AI clouding the outlook for some IT services businesses.

The good news is that volatile markets can be fertile hunting grounds for active managers. We are monitoring developments closely and thinking about potential implications for listed companies, but our over-arching focus on fundamentals and valuations is unchanged. In fact, we are looking to exploit short-term volatility, selectively topping up exposure to favoured positions at attractive valuations. Sticking to this tried and tested investment approach has helped preserve capital and enabled the strategy to outperform its benchmark during this period of elevated market volatility.

The AI tailwind

Selected technology firms in South Korea and Taiwan remain well placed to benefit from the AI theme and ongoing capital expenditure in data centres and other infrastructure assets. Again, recent volatility and weakness in some stocks have presented opportunities to adjust positioning in this increasingly influential part of the emerging market complex. We believe it is unlikely that conflict in the Middle East will have a lasting adverse impact on technology hardware companies. A meaningful proportion of AI-related capital expenditure continues to be deployed in Asia and should persist regardless of geopolitical turbulence; we would need to see a very large move in oil prices for the economics of data centres to be compromised.

At the same time, electricity grids need modernising in many developing countries and various companies stand to benefit from necessary upgrades or replacements of grid infrastructure. Again, the strategy has selected exposures to this long-term growth theme.

Positioning for a bounce in Brazil

In Latin America, we remain particularly attracted by the prospects for Brazilian firms. Presidential elections later this year could see a more business-friendly government elected, which could bolster sentiment and help boost corporate profitability.

Brazil is also home to some of the largest miners in the emerging market universe. The outlook for several commodity producers remains appealing, in our view, particularly those supplying gold and copper. Like in Brazil, commodity production is an important driver of growth in countries like Peru, Chile and South Africa.

We took some profits in mining-related names earlier this year and before the conflict started, but selective exposures are maintained in this area. The electrification theme mentioned above should support copper demand, for example. The outlook for gold remains strong too; fundamentals already looked positive before the start of the conflict, but increased geopolitical risk strengthens the outlook for gold as a ‘safe haven’ asset.

Long-term outlook remains supportive

Emerging market equities are trading at cheaper levels than their developed market peers, despite a superior long-term growth outlook. We expect this gap to narrow over time as investors increasingly recognise the supportive structural trends that are in place and as they feed through to corporate performance.

Importantly, there is also scope for interest rates to be lowered in many developing countries. Rate-cutting cycles are typically supportive of consumer spending and business investment and again could support sentiment towards markets more broadly.

The performance of the US dollar can influence sentiment towards emerging markets too and the currency outlook is less clear. Higher oil prices could lift US inflation and increase the likelihood of higher interest rates, potentially supporting the greenback, as could a broader ‘flight to safety’. That said, emerging market countries typically carry less US dollar-denominated debt today than historically, suggesting the performance of emerging markets could be less sensitive to movements in the US dollar than in the past.