Emerging Markets, Creative Destruction, and Moral Hazard

As the world attempts to appraise the extent of economic damage caused by the outbreak of COVID-19 we attempt to identify several forces that may lead to a further upset within emerging market equities, as well as point out several key indicators that are worth tracking. While certain countries have survived the worst of the pandemic, the economic consequences have yet to be felt by many emerging market nations. In this global economic sphere of influence globalisation begets international trade and co-dependence as much as mutually assured risk.

Emerging markets have come a long way since the last global financial crisis. The adoption of western practices for lean structuring, ESG principles, and deleveraging have made many companies resilient to challenges that would have otherwise crippled companies just a decade ago. Moreover, lessons learned from debt crises should have changed the ways debt is issued and secured. The rise in ESG investing has also forced companies within emerging markets to adapt operations in ways that provide investors with more protection in the form of a preemptive de-risking. The shifted investment scope was supposed to usher in a new age of investing, where capital is allocated only to good companies. In the wake of the COVID-19 crisis investors argued that these companies were simply subject to redemption cycles, are undervalued, and will perform well. Unfortunately, it is to my understanding that they are wrong. Only a handful of these companies will emerge from this crisis showcasing higher alpha. The problem lies in what emerging markets have come to mean for the western investment community.

Emerging market investors of the last decade tend to sort companies into one of two buckets; conforming and non-conforming.

The conforming bucket is composed of markets asset managers can easily pitch in their prospectuses, companies that are less of a nuisance to solve. Those that employ western management practices, use GAAP accounting, resolve to be politically neutral, transact internationally, actively employ debt, and comply – rather than conform – to principles of ESG. These companies have become the staple of every emerging market portfolio, with exposure shared across most EM mutual funds and ETFs.

In short, the emerging market companies bundled in most investment products today resemble western companies, but lack the same macroeconomic support. It is my expectation that these companies are expected to continue to underperform well into 2020, because a westernised emerging market with shared supply and demand risks is an incongruent premise and flawed by design.

The case for investing in emerging markets should not be out of similarity to western business practice, but in diversification into underdeveloped markets where companies face different challenges and risks. Emerging markets should not aim to verbatim copy the ideals of western markets, but to cherry pick only those traits that provide a marginal benefit to them within their own market. The latter is found in the second bucket.

Those companies deemed as non-compliant per western investment practices, those truly representative of an emerging market, are expected to yield marginally higher returns. The companies that prevail will be those that operate with isolationist economics. In the assumption of the creative destruction of globalisation, traditional companies will gain market share from those which collapse under the burden of international dependence (it is to be noted that the prospect of a pullback from globalisation does not explicitly imply a pullback from ESG, but rather western overbearing western practice.).

It is expected to be a considerable cause for debate whether a western emerging market will underperform a general emerging market, and how one would go about measuring the non-western emerging market is an issue in it of itself. Emerging markets attract investors because of the extent of diversity that they can offer. Measurements of success also vary: for instance, in cases where equity stock does not continuously trade – or where exchange volume is low- companies issue dividends at a higher frequency and value to shareholders. Ultimately, the burden of proof falls to active fund managers to prove the value of moral hazard.

As dollar-denominated debt and a strong dollar continues to limit policy space, my confidence lies in the expectation that fringe emerging markets will outperform novel emerging market brand names. With few current instruments offering relevant exposure to fringe emerging markets, investors should proceed with extreme caution. Nevertheless, isolationist emerging markets present a strong case for medium to long term growth, under attractive valuations and high expected risk premiums worthy of capital.

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