Emerging Markets: Wide Open

INVESTMENT PERSPECTIVES Emerging markets: Wide open

Constituent countries of the Global investors can manage their Homegrown companies that MSCI Emerging Markets Index capital appreciation objectives and compete at world-class levels of have experienced a growth improve overall portfolio resiliency efficiency are found with increasing miracle this century, propelling the by capturing the diverse secular prevalence in many countries and asset class to core status within return drivers that emerging sectors across emerging markets, a representative global equity market equities can contribute to offering skilled investors many portfolio today. well-constructed portfolios. attractive selection opportunities.

Introduction Berkeley Street Emerging Markets Equity Team Each January, the CES (formerly, the Consumer Electronics Show) showcases a wide range of the latest tech gadgetry from consumer electronics giants as well as many lesser-known upstarts from around the world. In keeping with the times, CES was a fully virtual event in 2021. In the last live event held in Las Vegas in 2020, self-driving cars and related technologies were the topics of no fewer than 18 sessions spread over the course of 4 days. Google’s Waymo and GM’s Cruise were joined by a variety of industry Derrick Irwin, CFA stakeholders, niche players, and lesser-known competitors. One of these was Yandex, Portfolio Manager, a Russian company that is actively developing autonomous driving software among WFAM its portfolio of technology-related business, which, according to Statista, includes a 60% share of the Russian internet search market. In 2020, significant performance improvements in Yandex’s autonomous driving software were demonstrated with 20-minute driverless test rides that shuttled over 100 passengers through the pedestrian-lined streets of Las Vegas, giving the company’s better-funded competitors a run for their money. The company has continued its rapid advancement in the space, Bob Hrabchak, CFA 1 Senior Portfolio Specialist, reporting over 7 million miles of autonomous miles to date. Yandex has carved out a WFAM credible presence among the experimental technologies that are making autonomous transportation a commercial reality, globally.

1. Yandex Self-Driving Group Clocks 7 Million Autonomous Miles, Forbes, 5/3/2021. The information shown is not intended to be, nor should it be construed to be, a recommendation to buy or sell an individual security. FOR INVESTMENT PROFESSIONAL USE ONLY – NOT FOR USE WITH THE RETAIL PUBLIC June 2021 At the turn of this century, most professional investors Investors may have again allowed recent emerging market were well aware of the vast reserves of world-class equity performance (this time disappointing) to shape engineers spread across emerging market countries. their expectations for the asset class. Indeed, continued Yet few would have expected that deepening capital relative strength of U.S. equities may have distracted markets and a growing entrepreneurial class could bring investors from the longer-term opportunity in higher- their talents to compete against industry titans today. growth parts of the world. We point below to some very Maybe it’s no surprise then that so many CES participants significant developments within the real economies of hail from countries that are considered emerging markets emerging markets that have continued unabated and that in the traditional, if outdated, taxonomy of investing, support a fundamental case for relative value in emerging including Russia, India, China, and Korea, among others. market equities going forward.

The pace of change may have made it easy to miss the Figure 1: Growth of $1 in two different periods scope of the transformation that has taken place deeper December 1999 through April 2011 within emerging market economies. The first section of this paper reviews some of the major growth milestones, 3.5 $3.18 giving some context for how one might think about the 3.0 future investment opportunity this asset class offers. For us, it’s as much about the potential portfolio benefits 2.5 a strategic allocation can provide to an intelligently 2.0 constructed portfolio as it is about its attractive absolute return and risk expectations. We believe the most 1.5 Growth of $1 $1.32 significant gains await skilled investors who actively seek 1.0 $1.14 value and specific exposure to the growing numbers of unique and attractive businesses that are poised for 0.5 leadership on the world stage. 0.0

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Performance, perception, and reality: How 2006 2008 2000 did we get here? MSCI EM-ND MSCI EAFE-ND S&P 500 We think the period from 2000 to the present can be divided into roughly 2 distinct periods that have shaped investor perceptions of emerging market equities as April 2011 through March 2021 an asset class. A look back at the year 2000 can remind 4.0 us how a variety of developments—from China’s $3.57 pending World Trade Organization (WTO) admittance 3.5 to the fruition of a common currency and an expanding 3.0 European Union—would mark major milestones 2.5 supporting globalization of trade flows and investment. 2.0 These underwrote positive expectations and performance $1.61

Growth of $1 1.5 for the asset class throughout the ensuing decade, leading $1.38 to a market peak in April 2011. The top panel of Figure 1 1.0 shows how an investment of $1 at the end of 1999 would 0.5 have fared over the period. 0.0 In spite of its sensitivity to two brutal recessions

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2017 2012 2021

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during the period, the MSCI Emerging Markets Index 2018 2020 (Net) returned a cumulative 218%, dwarfing returns MSCI EM-ND MSCI EAFE-ND S&P 500 of developed markets, and attracting significant investor flows. In the next decade, however, continued Sources: MSCI and eVestment Alliance, December 31, 1999, through March 31, 2021. The MSCI Emerging Markets Index was launched high expectations for emerging markets were largely on January 1, 2001. Data prior to the launch date is back-tested data unrewarded. The bottom panel of Figure 1 shows that U.S. (i.e. calculations of how the index might have performed over that time period markets have reaped outsized benefits since, with U.S. had the index existed). There are frequently material differences between back-tested performance and actual results. Past performance—whether large caps achieving a cumulative 257% return through actual or back-tested—is no indication or guarantee of future performance. March 2021. This has made the 38% achieved in emerging 2 markets seem lackluster by comparison. In fact, aggregate gross domestic product (GDP) growth ($3.2 trillion); and the Nikkei 225 in Japan ($3.9 trillion), experienced across developing countries this century has for example. Emerging markets have become one of the been nothing short of miraculous. Emerging economies most important equity allocations in a representative accounted for 21% of global GDP in 2000. Today, their global equity portfolio. share of global GDP has nearly doubled to 41%, according to the International Monetary Fund (IMF)—an astonishing The underlying mix of economic activities taking place uptake considering developed market economies grew in the more established emerging markets has also only moderately over the same period. We would be evolved dramatically. A reordering of supply chains within remiss not to call out China’s outsized contribution. emerging economies has moved many labor-intensive, Prior to joining the WTO, its impact barely registered lower-value-added export sectors offshore to lower-cost in spite of well-publicized supply chain integration and countries and to frontier economies that are now stepping inward capital flows. Once merely a curiosity, China is now onto the first rungs of industrialization. Industrial policies the most important global economy by purchasing power in the larger, more industrialized emerging economies parity and by share of global merchandise trade (according have aggressively targeted high-value-added industries. to IMF data sets and the WTO’s World Trade Statistical Perhaps China has defined the practice. For example, Review 2020, respectively). In Figure 2, the visible kink its “Made in 2025” initiative is channeling capital into a upward in the trajectory of global growth corresponds to variety of enterprises that are expected to produce global China’s official integration into global trade. first-mover advantages in high-tech manufacturing and global networking. Many other development plans are Figure 2: Emerging economies are a growing percentage also choreographed and, therefore, telegraphed to market of global GDP participants to some extent. These signals can clue active 120 investors in on which companies stand to benefit or suffer Emerging markets Developed markets under various scenarios. 100 More deeply, the realignment taking place within certain 80 countries and among them, through integration, presents China enters WTO 60 powerful forces that investors can anticipate and that we believe provide attractive investment themes that apply to 40 a number of investment opportunities. One theme to call World GDP ($B) out in particular is prevailing demographic trends. These 20 vary regionally and are critical for investors to grasp to gain 0 confidence that the companies they own have the proper consumer strategies where they operate. We outline some 2012 1992 1984 2016 1996 1988 1980 2020 2004 2008 2000 of these demographic considerations in the next section. 2024E EM% 24 22 18 16 20 21 22 31 38 39 41 42 DM% 76 78 82 84 80 79 78 69 62 61 59 58 Demographics are key to understanding Source: IMF datasets as of April 30, 2021. the next leg of growth in emerging Periods beyond publication date are forecasted. markets Reflecting the strength and breadth of real economic Several emerging market countries in South Asia, the growth, emerging market equities have grown rapidly Middle East, Africa, and Latin America have young and in their importance among global capital markets. growing populations that present their own growth Consider that the flagship MSCI Emerging Markets opportunities. In more mature markets, primarily in the Index was created in December 1987, encompassing 10 Asia Pacific region, overall population growth has been countries with a total market capitalization of only about slowing but the middle class is expected to grow rapidly. $52 billion. This represented a sliver of aggregate global The Brookings Institution has estimated that this group will market value at that time. Yet, by April 2021, the index grow an astonishing 38% in aggregate, or by about 1.5 billion included 27 countries worth $8.2 trillion in equity market people over the next decade—roughly 4.5x the size of the cap—representing growth of over 15,800% in nominal total U.S. population. More people spending more per capita terms. To put this figure into perspective, consider the is rapidly transforming the consumer economy. current sizes of indices that have been important to global investors for far longer: FTSE 100 ($2.6 trillion); FTSE 350

3 Taken together, overall population growth and a new For investors, this supports a case for renewed expected middle class should be important factors contributing to return optimism in the long term, particularly for those the increasing relative importance of emerging market who can target the various growth themes we described economies in the share of global GDP. The World Bank has above. However, we think a greater recognition of the estimated that they will contribute 70% to global growth diversification potential this asset class can provide is later this decade. overdue in today’s global market environment. We discuss this in the next section and conclude by considering To summarize, we believe expected economic growth across why emerging markets should be a key part of any well- emerging markets will be structurally more diverse and constructed global equity portfolio. dynamic than ever before and that fundamentals will support high absolute levels of real growth for decades to come. Building resilient portfolios with emerging markets Figure 3: Emerging markets will drive global growth and wealth creation in the next decade Part of the process of building resilient portfolios is to take full advantage of the available investment universe. Population of global middle class by region Including emerging market equities in a strategic portfolio 6 5.41 allocation may increase the likelihood of achieving a desirable range of outcomes over the specific investment horizon of 5 4.62 an investor. For many, this means that a significant allocation 3.90 can provide access to attractive long-term expected growth 4 rates to pursue capital appreciation objectives, as noted 3.14 above. Meaningful allocations may also improve overall 3 portfolio risk-adjusted returns through diversification. Billions

2 Figure 4 shows that rolling 60-month correlations between U.S. and emerging market equities have been 1 on a downward trajectory ever since 2000. This belies perceptions that return correlations between U.S. and 0 emerging market indices should inevitably rise due to 2015 2020 2025 2030 tighter economic integration. Rather, lower realized North America Europe Asia Pacific Latin America correlations may reflect growing independence and unique Middle East & Africa return drivers. Indeed, trade flows among emerging market countries have grown larger than flows between emerging Source: The Brookings Institution data estimates. The periods 2025 and 2030 are forecasts. and developed markets, according to the WTO.

Emerging markets are expected to contribute over Figure 4: Declining correlations between the S&P 500 70% of global growth later this decade and MSCI EM-ND indices may improve overall portfolio 100% diversification 100 90% 90 80% 80 70% 70 60% 60 50%50

Percent Percent 40%40 30%30

20% Correlation coefficient 20 10% 10 0% 3

0 0 ne ne De De De ept ne De ept ar ept ar ar ar 2012-2017 1990-1995 2018-202 19 95-2000 2023- 2028 2028-203 2000- 2005 2005-2008 1990–1995 1995–2000 2000–2005 2005–2008 2012–2017 2018–2023 2023–2028 2028–2030 Sources: MSCI and eVestment Alliance. Presents 60-month Emerging markets Developed markets correlations between the MSCI EM-ND Index and the S&P 500 Index rolling monthly, capturing the period from January 2000 through Source: The World Bank data and HSBC Global Research estimates. March 2021. A trend line (dotted) for the full period has been 4 The periods 2018-2023, 2023-2028 and 2028-2030 are forecasts. overlaid. Past performance—whether actual or back-tested—is no indication or guarantee of future performance. Most global investors maintain strategic allocations to this asset class. However, the significantly increasing representation of emerging markets in global equity market capitalization over this period means that some investors may be playing catch-up to a representative allocation. Figure 5 shows performance attributes of a simple hypothetical 60% equity/40% bond portfolio with different historical allocations among equity components since 2000. It shows how modest increases in emerging market equities taken in equal parts from the developed market equity components would have meaningfully improved the overall portfolio’s risk-adjusted return profile. It is likely that even lower expected return correlations between emerging and developed markets in the future would only improve the asset class’s potential as a portfolio diversifier.

Figure 5: Greater strategic allocations to emerging market equities could have improved overall portfolio efficiency since 2000

Emerging market allocation 0% 5% 10% 15% 20%

Annualized return 5.40% 5.57% 5.73% 5.89% 6.03%

Sharpe ratio 0.385 0.396 0.405 0.411 0.415

Sources: MSCI, eVestment Alliance, and Wells Fargo Asset Management (WFAM). Assumes annual rebalancing among portfolio segments. The fixed income segment is static over the period with 5% allocated to the FTSE 3-Month U.S. T-Bill Index and 35% to the Bloomberg Barclays Global Aggregate Bond Index. Dynamic allocations to equities are made among the Russell 3000 Index, the MSCI EAFE-ND Index, and the MSCI EM-ND Index, which total 60% in all scenarios. All performance presented is based on total return indices. The percentage allocation to emerging market equities presented in the table is with respect to its weight in the total portfolio. The risk-free rate used in the Sharpe ratio is 1.61%. Presents hypothetical performance statistics from December 31, 1999 through March 31, 2021. Past performance—whether actual or back-tested—is no indication or guarantee of future performance.

Figure 6: Correlations among the largest country constituents of the MSCI Emerging Markets Index (average: 0.57)

South Argentina Brazil China India Korea Russia Taiwan Africa

MSCI Argentina 1.00 0.48 0.36 0.34 0.44 0.45 0.48 0.36

MSCI Brazil 0.48 1.00 0.53 0.52 0.62 0.70 0.73 0.58

MSCI China 0.36 0.53 1.00 0.51 0.75 0.52 0.61 0.70

MSCI India 0.34 0.52 0.51 1.00 0.60 0.49 0.61 0.68

MSCI Korea 0.44 0.62 0.75 0.60 1.00 0.62 0.73 0.76

MSCI Russia 0.45 0.70 0.52 0.49 0.62 1.00 0.65 0.53

MSCI South Africa 0.48 0.73 0.61 0.61 0.73 0.65 1.00 0.66

MSCI Taiwan 0.36 0.58 0.70 0.68 0.76 0.53 0.66 1.00

Sources: MSCI, eVestment Alliance, and WFAM. 10 years ending March 2021 using monthly returns. All country correlations presented are between total return indices, net of withholding taxes. Past performance—whether actual or back-tested—is no indication or guarantee of future performance.

5 We pointed out some long-term growth drivers above, Conclusion but there are also arguments supporting a nearer-term catalyst for emerging market equity outperformance. This paper has briefly outlined the evolution of emerging Figure 7 shows that historical valuations of emerging market equities as an asset class for today’s global investor. markets relative to developed markets are currently The pace and magnitude of growth and development have attractive. A reversion to mean historical levels would been so significant this century that we believe some widely support positive relative returns over developed markets. held perceptions of the opportunity may not have kept This scenario could be spurred on by bold monetary policy pace with reality. While we expect future economic growth of central banks in emerging economies. and absolute return levels will ultimately remain compelling

in both near- and longer-term horizons, investors should As we have discussed above, we think disciplined, active also recognize the immediate and significant diversification approaches to emerging market equities can improve the benefits of emerging market allocations in well-constructed overall quality of an investor’s exposure to this asset class global equity portfolios. and ultimately contribute to greater resiliency of their overall portfolio. We think one of the most underappreciated attributes of Figure 7: Relative valuations are supportive of emerging this asset class is the considerable expansion in breadth market equities of economic activities taking place in emerging markets. A second is the proliferation of world-class companies Relative valuation of emerging markets that operate regionally or globally, regardless of their vs. developed markets physical headquarters location or primary exchange listing. We opened with an example of one Russian company that may at first glance have looked at home in the U.S., Japan, or Germany. Yandex has provided its shareholders considerable value by taking a credible position in one of the most important transportation sectors of the future with a mere fraction of the capital committed by the industry’s leaders. We think such stories

of capital efficiency and world-beating innovation will

atio o prieook vale be increasingly common across emerging markets for decades to come. At WFAM, the Berkeley Street Emerging Markets Equity team believes that bottom-up fundamental research Emerging market vs developed market eities has always been the best way to find the most attractive opportunities within the vast and growing group of Sources: Alpine Macro and MSCI, April 30, 2004, through March 31, 2021 companies that make up emerging market equities. Companies with an attractive business mix and whose management has the vision, leadership, and means to execute their business strategy can be excellent candidates for investment, particularly when they can also be purchased at compelling valuations. At the portfolio level, we think these companies can help investors pursue the expected growth, diversification, and alpha required to achieve their strategic investment goals.

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The Morgan Stanley Capital International (MSCI) Emerging Markets (EM) Index (Net) is a free-float-adjusted market-capitalization-weighted index that is designed to measure large- and mid-cap equity market performance of emerging markets. The MSCI EM Index consists of the following 26 emerging market country indices: Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and the United Arab Emirates. You cannot invest directly in an index. Source: MSCI. MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI. The views expressed and any forward-looking statements are as of June 11, 2021, and are those of Berkeley Street Emerging Markets Equity team and/ or Wells Fargo Asset Management. The information and statistics in this report have been obtained from sources we believe to be reliable but are not guaranteed by us to be accurate or complete. Any and all earnings, projections, and estimates assume certain conditions and industry developments, which are subject to change. The opinions stated are those of the author and are not intended to be used as investment advice. Discussions of individual securities or the markets generally are not intended as individual recommendations. The views and any forward-looking statements are subject to change at any time in response to changing circumstances in the market and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally, or any mutual fund. Wells Fargo Asset Management disclaims any obligation to publicly update or revise any views expressed or forward-looking statements. All investing involves risks, including the possible loss of principal. There can be no assurance that any investment strategy will be successful. Investments fluctuate with changes in market and economic conditions and in different environments due to numerous factors, some of which may be unpredictable. Each asset class has its own risk and return characteristics. Wells Fargo Asset Management (WFAM) is the trade name for certain investment advisory/management firms owned by Wells Fargo & Company. These firms include but are not limited to Wells Capital Management Incorporated and Wells Fargo Funds Management, LLC. Certain products managed by WFAM entities are distributed by Wells Fargo Funds Distributor, LLC (a broker-dealer and Member FINRA). FOR INVESTMENT PROFESSIONAL USE ONLY – NOT FOR USE WITH THE RETAIL PUBLIC