Look beyond trade tensions for sustainable growth trends

There always seem to be potholes in the road to emerging markets.

Just this year developing country stocks have overcome bouts of volatility tied to U.S.-China trade talks, concerns over China’s slowing economy, shifting global monetary policies and election jitters. The result: the benchmark MSCI Emerging Markets Investable Markets Index was up 10% in U.S. dollar terms in the six months to June 30.

What often gets lost in the daunting headlines are innovative advancements and growing investment opportunities in developing countries. Although trade issues are likely to spark volatility for months to come, many companies in emerging markets aren’t significantly exposed to international trade disruptions.

Some of China’s largest and most well-known publicly traded companies — internet giants such as Alibaba, Tencent and Ctrip, for example — predominately rely on domestic consumption. The same goes for fast-growing private sector banks in India or Asian insurers selling products to wealthier consumers.

As emerging markets have matured, company fundamentals have become the key drivers of returns, making stock selection more relevant.

Maintaining a focus on fundamentals

"In this environment, we're focused on companies with strong balance sheets and those addressing sustainable secular growth trends in emerging markets," says Kent Chan, an investment director at Capital Group focused on emerging markets.

Some of those trends include:

• Growth of mobile e-commerce and services
• An expanding consumer class in Asia
• Market share gains for India’s private sector banks
• Soaring demand for air travel in Asia
• Semiconductors for artificial intelligence, cloud computing and industrial automation

What’s more, "Free cash flow yields have held up despite macro uncertainty and trade tensions. Valuations remain attractive on a historical basis as well compared to developed markets, creating opportunities to selectively invest in high-quality companies," Chan adds.

Navigating China’s slowdown

Investor worries about China are ubiquitous, and market conditions will be rocky at times, depending on the policies Chinese leaders take to sustain economic growth and reshape trade relationships.

It’s clear the U.S. trade dispute has complicated Beijing’s multiyear plan focused on improving the quality of growth, reducing debt and curbing risks in parts of its economy like shadow banking.

China’s economy is expected to slow, but it remains one of the fastest-growing in the world. The government still has plenty of levers to pull, including new stimulus measures, tax reductions, funding additional infrastructure projects and allowing credit availability to grow at a stronger pace.

“China will need to further stimulate its economy given current conditions,” says portfolio manager Chris Thomsen. “While a final trade deal with the U.S. won’t be perfect, I’m optimistic that once an agreement is reached, it will be a catalyst for long-term growth, much like when China joined the World Trade Organization in 2001.”

As it relates to trade tensions, some developing countries may benefit.

Many global manufacturers are looking to diversify capacity beyond China, and this development might provide a boost to already solid domestic growth rates in several Southeast Asian countries.

“We are beginning to see a structural shift in global supply chains," explains portfolio manager Winnie Kwan. "The trade tension is a catalyst for China to move up the value chain at a faster pace. The country is retaining the higher value-add manufacturing capabilities, and developing new industries and services.”

As a result, “Asia is forming a supply chain ecosystem, benefiting smaller developing countries that can manufacture lower value-add goods and/or supply China with resources the domestic consumer market needs,” Kwan adds.

China’s innovation runway

China’s private sector is vibrant, and competition is fierce in the technology and consumer sectors.

China would like large-scale national champions in key industries that can compete with the developed world. Alibaba and Tencent are the most high-profile examples. These savvy entrepreneurs have created sophisticated internet companies that have in many ways evolved beyond their Silicon Valley counterparts in areas like messaging, social media advertising and payments.

“I have invested in many exciting and innovative companies in China run by entrepreneurs,” Thomsen says. “Due to the scale of the domestic market, it’s one of the few countries where a company can quickly scale its business and evolve from a small firm into a much larger, more valuable company.”

Not every company will be a success. The challenge is to find pockets of growth in sectors where there are large addressable markets and effective management teams running those businesses. Over-capacity, lack of pricing power, technology theft and counterfeiting are key challenges.

Where might the next winners be? Potential areas include health care, tourism and software.

Can’t ignore China’s role in EM universe

Trade disputes aside, the veil is lifting on China’s domestic stock market, positioning it to become a larger slice of the emerging markets universe. China’s stock market will continue to be driven by foreign capital inflows, especially as Chinese companies become a greater part of the benchmark MSCI Emerging Markets Index

More than 800 Chinese-domiciled companies, known as A-shares and traded locally on the Shenzhen and Shanghai stock exchanges, are expected to become available to investors outside of China during the next few years.

It’s a stock great environment for fundamental research. Even if only a small fraction of those companies wind up being viewed as attractive investment opportunities, the extensive research needed to identify them should be worth the effort. Imagine finding the next Alibaba, Tencent or Baidu in that mix.

“I view China as a classic stock picker’s market. It’s a vast universe with a wide disparity in terms of the quality of companies in which to invest,” Kwan says. “There are a number of stocks that aren’t attractive from a valuation or corporate governance standpoint. But, I do believe there’s potential for some A-share companies to become much larger in market value, especially when I evaluate opportunities in areas of China’s new economy.”

Invest in sustainable growth trends

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