Carolyn Bigda: Hello, and welcome back to Global Perspectives, a podcast created to share insights from our investment professionals and the implications they have for investors. I’m your host, Carolyn Bigda, filling in for Lara Castleton, who is on the road meeting with clients.

And speaking of travel, on this episode, we are talking to Portfolio Manager Daniel Graña. He heads the Emerging Market (EM) Equity Team and joins us remotely from his office in Boston, Massachusetts. Daniel also recently finished a two-week trip to Asia, where he met with companies to discuss growth stories, such as AI, the reshuffling of global supply chains, and so on. So, we look forward to getting his latest insights on EM today.

Daniel, welcome to the podcast.

Daniel Graña: Thank you very much.

Bigda: If we start the conversation by providing some context for listeners, emerging market equities, as a whole, has trailed developed market peers so far in 2024. They did so in 2023, and several years before that, as well. Can you talk about what has been weighing on the asset class?

Graña: I think if you reframe the question to say, why haven’t emerging markets done better than U.S. equities, then I think you’ll gain an appreciation of what we’re really trying to get at, which is that why have U.S. equities done so well? And the reality is that the S&P 500® [Index], most of the performance has come from a handful of names. And these are the innovators and disruptors of our time – the Apples, Nvidias and Metas – and those stocks have done extraordinarily well.

We are now beginning to see our own raft of innovative companies going public and having an impact, much like what we saw in the United States back in 2009. Broadband internet penetration today in emerging markets is roughly where the U.S. was back then. And so, we’re seeing very exciting companies in biopharma and fintechs and global green energy supply chain. As you recall, Tesla isn’t the biggest EV [electric vehicle] OEM manufacturer. It’s actually a Chinese company. And so, while we certainly have some things to consider in emerging markets, like geopolitics, U.S. Fed [Federal Reserve rate] cycle, China macro issues, our starting point today is very attractive in terms of what is being offered.

Bigda: So, it sounds like the innovation there is in the early stages of ramping up. Is that correct?

Graña: That would be exactly right.

Bigda: And you mentioned China, and when you look at the index, as a whole, China has been sort of maybe the biggest drag on performance, recently. And I think some of our listeners might be wondering, well, is there a place for Chinese equities in an emerging markets portfolio today?

Graña: Absolutely. I think it would be fair to say that China is in the process of dealing with the hangover of its excesses of the last economic model. They relied a lot on fixed asset investment growth, things like property, and so, there’s a lot of unresolved issues with China.

But at the same time, you ignore China at your own peril. Most of the world’s solar supply chain is in China. Most of the world’s wind supply chain is in China. A lot of the exciting biopharma companies are also in China. And so, I think the end result is, you’re going to have to thread a few needles. The needles are, of course, the rise in geopolitical rivalry between China and the U.S.; China’s transitioning its economic model; and you have to be very careful about political governance and how that intersects with our companies. But I think if you focus on the right innovative companies that are aligned with the national development goals of the Chinese Communist Party, then I think you can do quite well in China.

Bigda: Looking at EM as a whole, consensus expectations are much more positive for 2024, with some analysts pointing to improving economic trends, accommodative monetary policy, and the potential for strong earnings growth, which seems to be the key thing for 2024. Do you share in that outlook broadly for emerging markets right now, Daniel?

Graña: I would say there’s several reasons to be excited about emerging markets today. One is where we are in the economic model. So, we started hiking interest rates before developed markets did, and we’ve now started to cut interest rates before developed markets have. And so, cyclically, we’re going to look better in 2024 relative to U.S. markets than we have in a very long time. As a matter of fact, if you look at the GDP [gross domestic product] growth of emerging markets, it’s expected to be more than three percentage points faster than developed markets this year, which is typically the time when emerging markets start to outperform. And so that’s the sort of the cyclical.

But a lot of the things that are happening in developed markets that are very exciting, such as artificial intelligence, most of that supply chain – you know, Nvidia is a very exciting company, but most of that company’s supply chain are actually in emerging markets. And so, the kinds of structural stories that get people excited in developed markets resonate in emerging markets as a result. And so, we find lots of places to hunt in emerging markets that make it a very attractive asset class for 2024.

Bigda: So, before we get into some of those secular growth themes, let’s talk just quickly about interest rates because that’s always an important detail for emerging markets. You mentioned that emerging markets are a little bit ahead of the game in terms of cutting rates. What about for the U.S., though? What happens if the Federal Reserve takes longer to cut interest rates? How does that impact the outlook for the sector? And then what happens when they eventually do start cutting?

Graña: So, we are at the point in the economic cycle when headwinds turn into tailwinds. And so, when the Fed starts cutting, that’s good for this asset class. This is the riskiest asset class. A disproportionate share of the external liabilities of countries and companies are financed in [U.S.] dollars. So, the cost of dollar debt really does matter. The cost of the option of an equity market in the U.S. doing well, that’s also to be factored in.

So, you’re right that if the Fed is going to be slower to cut, that tailwind maybe is not as strong as we would have liked. But nevertheless, it’s no longer the headwind that it was, say, in 2021 and 2022, heading into 2023; there were legitimate question marks how far the Fed had to go, how much quantitative tightening had to be done, shrinking of the Fed balance sheet. And so, I think we’re past the point where we worry about a higher Fed, but now we’re thinking about the pace at which it decreases.

Bigda: Has the reset of Fed rate-cut expectations, has that been why maybe emerging markets have been a little bit slower to start the year?

Graña: That would be a fair comment to make. One is that we’ve been slower to take off as a result of that resetting of expectations. Another sort of factor is, of course, the raft of elections this year. And of course, the most important election is the U.S. election in November. And as we saw with the prior administration under Trump, that does have an impact on emerging markets through the renegotiation of NAFTA [North American Free Trade Agreement] with Mexico, for instance, or the trade war with China. And so, as people are sort of resetting expectations about what the elections might do to emerging markets, I think that’s another reason, to say, that emerging markets haven’t done what we would expect them to have done, given where we are in the economic cycle.

Bigda: So, if we look at EM – because it is a big asset class – if we look at it from a regional level, are there certain areas within EM that look particularly interesting right now, whether it’s because they are further along on their rate-cutting cycle, whether it’s because they’re benefiting from some supply chain adjustments? What regions in particular, to you, look attractive now?

Graña: There’s a few answers to that question. One is, certainly, when we talk about supply chain re-architecture away from China – that’s effectively what we’re talking about here – what is it that multinationals look for? They look at attractive manufacturing costs, they look at access to big end markets or free trade agreements with the U.S., Europe, or Japan. The ability to have a supply chain move there, access to labor. All that means that there’s a few countries in emerging markets that stand out in terms of beneficiaries of deglobalization – certainly Mexico, Indonesia, Vietnam, and India. And so those four countries are key beneficiaries of deglobalization.

But I’d also add that on a standalone basis, India is the best story in emerging markets from a long-term basis. We could see India credibly growing at high single-digit GDP growth for many, many years based on the demographics; based on the homework that they’ve done for reforms; based on the impact of a very low starting point in urbanization, moving people to the cities; the infrastructure investment that they’re doing; the fact that management teams understand the role of capital markets; generally, the policy framework is a lot more transparent.

And so, as a result, we could see certain EM countries growing fast, but no one in emerging markets can grow fast and for as long a period of time than India can. And so, yes, from a structural theme, the end of China as being the global workshop over time – and certain countries will benefit from that. There are certainly exciting stories within emerging markets, as I said, those four countries that I identified. But on a standalone basis, India is the most stellar story within emerging markets.

Bigda: Now, India is heading to the polls towards the end of April. Does that election pose any risks to this long-term outlook?

Graña: Always elections, especially since the polls have been so wrong across elections everywhere in the world. Yes, so in emerging markets, we have to monitor because the difference in the candidates are not shades of gray, like they can be in developed markets. And so, the expectation given more recent state elections and the polls would be that Modi would win a third term, and therefore, policy continuity and everything that I just said would be reinforced. So yes, we would need to monitor the results of the election, but all signs point to policy continuity, which is what I think the markets would really reward.

Bigda: Now, India is interesting because it has a lot of growth potential, but it also has maybe some of the higher valuations within emerging markets, is that correct?

Graña: Yes, so whether self-relative – so, India relative to its own history – or relative to emerging markets, India is certainly trading very expensive. And so, here you’re going to have to be more careful about choosing your spots. I don’t think just owning everything in India makes sense given where valuations are. There’s also been a push by locals shifting some of their sort of investment pocket toward equity markets, and so, that’s providing structural tailwinds to the rerating story in India. But I think on any meaningful, on any reasonable pullbacks, I think this is the story to own from a long-term perspective.

Bigda: Now, if you look at EM broadly, there has long been a valuation gap between developed market and emerging market equities. And that gap, broadly speaking, is alive and well today. Is there a reason to think that gap could start to shrink going forward, where multiples could expand, whether it’s because of innovation or other factors?

Graña: So, we start with talking about the starting point. The starting point is that we are trading… so, emerging markets has historically traded a discount to developed markets, but the discount that we’re trading at today is below the usual discount. So, in other words, it’s a wider discount than usual. And so, even just closing to average levels would represent support for equity markets and emerging markets. But one could argue because of the widened growth differential – EM is expected to grow faster economically this year than developed markets – that maybe we can trade through that sort of average discount level.

The other is the earnings cycle. Given that many, many economists are expecting a slowdown in growth in Europe, the U.S., and Japan, we should start to see that reflected in earnings growth being perhaps more disappointing, whereas we’re just starting our earnings upgrade cycle [in EM]. So, earnings likely to beat the developed market peers, and the starting-point valuations are cheaper than average.

Now, given that the risk factors are there, right? So, there’s more uncertainties on politics. There’s more uncertainty about business practices and corporate governance, emerging markets should always trade at a discount to developed markets, but just that discount today is too wide.

Bigda: And I’m guessing that some of that earnings growth is coming from the innovation that you alluded to earlier. And you’ve long talked about innovation as being a major impetus for growth in emerging markets in the coming years. Can you give some examples of the innovation that you’re seeing, and you are most excited about?

Graña: There’s a fintech company in Latin America that is not only successfully competing against the established players in Brazil – and they’ve done quite, quite well in that, being the number one bank or choice bank by many customers, more so than many of the incumbent banks, and showing decent profitability, which isn’t always the case, by the way, in fintechs around the world. They’re now taking that model and exporting it to other parts of Latin America. The reason why that gets us excited is that the unbanked and underbanked populations in Latin America are very high. So, in the case of Mexico, for instance, more than 50% of the population does not have a bank account. The incumbent banks feel very happy targeting that top third of the income pyramid and can’t seem to get the economics right to go beyond building a branch network, beyond where the top third are living and working. Of course, technology changes all of that, and that’s what gets us excited.

The innovation, of course, is the smartphone penetration, the broadband penetration allows you to do banking service from your smartphone. You don’t need a bank branch. Imagine as a shareholder, you’re talking about a fintech that’s going to have many, many years of growth with very limited competition. And oh, by the way there’s also positive ESG [environmental, social, and governance] implications of financial inclusion. So, for all those reasons, we can get very excited about this fintech company in Latin America.

Another is a technology wizard company in Taiwan. And you know, on the shelves in supermarkets, you see a product in front of you, you see the edge of the shelf has the price for the product. All that now will be digital. Except, it won’t be just black and white, it will be color. And so, we’ve already started to see this roll out in Europe; the U.S. is a little behind, but some of the retailers in the U.S. are beginning to roll it out. This is exciting because it’s now a whole new addressable market.

What does that do for the retailers? Well, it takes a lot of people, expensive labor, to replace all those labels in the stores. You can do dynamic pricing. If a lot of people skip over certain sections, maybe you can dynamically change the price and lower the price to attract people to perhaps take the product off the shelf. And so, these are the kinds of innovative companies that we can get behind. These are the kinds of things that happen in emerging markets that perhaps are not as well known in developed markets.

Bigda: And have you seen this in place yourself already in different stores?

Graña: I have. I think certain stores decide to make it very lowkey, so you don’t even notice it as much. But others actually want to take the full advantage of the full functionality and use color and so forth. So, I think it really depends on how the retailer wants to use this technology.

But other examples for technology would be GLP-1 drugs that help control diabetes and weight loss. There is a Chinese company that is in the forefront, developing this drug, and it will be another competing drug alongside those that are presented by multinationals. So, we have companies that can stand on their own in terms of their innovation. We’re not just making widgets for the global supply chain. We represent a lot of innovative ideas that will be globally competitive.

Bigda: So, these companies are pushing the frontier out, essentially, when it comes to these different areas. But as you had mentioned earlier, they are big components to major themes such as AI. They are providing the parts that are critical to these huge secular growth drivers. And so, didn’t know if you could just touch on AI very quickly and how some EM companies are potentially going to benefit from that trend.

Graña: Everyone knows about Nvidia, the U.S. company that is responsible for designing a lot of these chips that are used for artificial intelligence. But Nvidia doesn’t manufacture; that’s EM companies. And when you manufacture these chips, you also need a lot of memory because what you’re doing is feeding a lot of data for it to make connections. And those memory chips are made by emerging market companies. And then you package them in servers, and then you need to cool the servers. Cooling of the servers – emerging market companies. The packaging of the servers – emerging market companies. And so, a long train of the supply chain that enables AI are emerging market companies.

Bigda: You often speak of the role that governance plays in security, country selection. Can you just elaborate a little bit on governance and how this overlay should help sort of maybe mitigate some concerns that investors might have about EM today?

Graña: So, you cannot invest in emerging markets without a view toward corporate governance, how the controlling shareholder treats minority shareholders. And let’s keep in mind that the overwhelming majority of companies in emerging markets have a controlling shareholder, so it’s either the state or a family. So, you have to care about what the majority shareholder wants to do with the company, but also you need to care about political governance, which is, think of it as the operating environment these companies swim in terms of their relations with the government, their relations with the regulator. And so, if you do not incorporate these important dimensions into your process – corporate governance and political governance – then you’ll be surprised and not always for the better.

We have successfully navigated a lot of the emerging market issues precisely because we include this as part of our process. We hunt in the intersection of good companies in good countries with good governance. So corporate governance, you have to understand that acceptable business practices are very different in emerging markets. The quality of the regulators, the accounting standards are different in emerging markets. And so being able to ask those questions – related party transactions, what might the majority shareholder do to the empire building versus returning capital to shareholders – those are all very important questions in emerging markets.

But I think the additional layer, the additional complication that perhaps you don’t run into in developed markets is political governance. Tell me about the company’s relationship with the regulator. Tell me about their relationship with the ruling party. What happens if the ruling party changes? These are the kinds of questions we ask to make sure that we avoid the landmines in emerging markets. And admittedly, in emerging markets, again, because we are at a different stage of our economic and political development, these kinds of landmines do appear more often in emerging markets than they do in the developed market counterparts.

Bigda: So, emerging markets remains underrepresented in many investment portfolios. Why should investors reconsider and add to their EM holdings or initiate a position if they haven’t already?

Graña: A nice short way of putting it would be, why would you want to buy a very narrow U.S. equity market that maybe is overvalued when you could buy into an under-owned, cheap, innovative, growthy emerging markets with policy tailwinds? I think it isn’t a question of either or. It’s a question that the U.S. equity markets have done so well and emerging markets relatively haven’t, that maybe now is time to start leaning into the direction of emerging markets. We do offer the growth, we do offer innovation and at cheaper valuations. And you should be investing where others are not, not necessarily where everyone else is crowded into.

Bigda: And emerging markets, they are a big piece of the global economy, and it sounds like they’re just growing even larger. And so, to miss out on that seems like it would be a missed opportunity.

Graña: Absolutely, absolutely. And so again, as I said, who’s the largest manufacturer of electric vehicles? It’s an emerging market company. Who’s the largest manufacturer of electric vehicle batteries? An emerging market company. So, there’s lots of exciting stories within emerging markets that are globally competitive, that are trading at much cheaper valuations.

I think to ignore emerging markets at this stage after the spectacular outperformance of a handful of names in the U.S., I think would be unfortunate.

Bigda: Well, you make a pretty good case there, Daniel. We appreciate getting your expertise and outlook on what is a complex asset class, but one that seems pretty important, especially maybe at this point in the market cycle. So, thank you for joining us.

Graña: Thank you, thank you for your time.

Bigda: And that’s it for us. You can find other episodes of Global Perspectives on our website, janushenderson.com, or wherever you stream or download your podcasts. I’m Carolyn Bigda. Thanks for listening.