Hello, and welcome back to Unlocking Markets, our RBC podcast series. This is where we bring you our experts from across the firm, provide their opinions on the macro environment and discuss how top-down themes help influence the way they invest. I'm Mike Reed, Head of Global Financial Institutions. Today I'm going to be talking to Laurence Bensafi, who is both a Portfolio Manager and Deputy Head of Emerging Market Equities. Today we’ll be covering a range of topics that we believe all investors involved in EM equities should be thinking about.

The recent G20 meeting was hosted in India by Prime Minister Modi and there was much talk about the rise of the Global South, which is dominated by emerging market countries. This can be seen by their increasing share of global GDP.

Today we’ll be considering their big picture themes and also discuss how the latest developments in Artificial Intelligence and ESG integration are impacting EM portfolios. Welcome Laurence.

Hi, Mike. Thank you for having me on this podcast.

Laurence, despite emerging markets growing share of global GDP for several years now, EM equity markets have significantly underperformed their developed market peers. What do you think have been the reasons for this and why is this time different?

Yes, indeed Mike, EM equities have really underperformed. To be fair, EM equities were flat during the period, but it's really developed equities and in particular US equities that have been really strong. The main reason really is that in the end we never really recovered from the global financial crisis. For 10-plus years we didn't have a recession but it felt like a really difficult environment, a risk-off environment. In that environment we had low inflation, low interest rates, low commodity prices and a very strong dollar. That really helped developed markets.

What we think is different now is that we are entering a new regime, a new environment where all those factors reversed. We are probably in a higher inflation, higher interest rate environment for longer, higher commodity prices and at some point, a weaker dollar. All that is going to be much more positive for emerging markets equities and we expect an outperformance in the years to come.

That sounds like good news. Now, let's talk more specifically about China. Chinese equities dominate EM indices and have been a drag on overall performance. Going forward, what are some of the major themes you believe will be driving both the Chinese economy and its stock market?

You're right. Recently, China has been a drag but for quite a long time China has been doing actually quite well; obviously superior economic growth, quite a diversified economy. We had a strong technology sector, with e-commerce companies that did really well. You're right, over the past two, three years it's been more difficult for the China equity market. Going forward, we still think that there's a lot of potential for this economy, but it all comes down to the ability of the government to rebalance from an investment, real estate, CapEx-driven economy to a consumption economy.

The consumption level in China is much lower than in pretty much every other country. People save a lot of money because they don't feel they can spend as much because the safety nets are not really there in the country. There's huge potential for China to create this huge consumption economy that would drive economic growth for years to come. We don't know yet if this is going to happen. It's a big challenge for the government but the potential is there for sure. That should really help the equity market when that happens.

Good to hear again. Let's switch gear a little bit here. The Indian population is now estimated to exceed that of China, becoming the most populous country in the world. We've also witnessed similar relative performances of their stock markets. From your perspective though, is India still a market rich in investment opportunities?

Yes, you're right. India has done quite well the past few years for the stock market. It's actually the most expensive country in emerging markets. You may think, yes, maybe it's a bit too late. Having said that, we still think there are a lot of opportunities in the country. The country just had eight years of a huge amount of reform, economic reform. Prime Minister Modi has really transformed the country. You're right when you introduced at the beginning that for the first time India hosted the G20. I think it was a big show of the strengths and the potential growth for the country.

Every other country has wanted and is working very hard to sign trade agreements with India, because India is now in a position where they're going to increase massively their spending and buying planes and trains, so everyone wants to be involved. We are very positive. The transition, those eight years of reforms, was actually not an easy period because when you have a lot of changes in the country, it impacts economic growth.

Actually, the economic growth over the past few years has been below par, but we feel like India is just at this period of time where now it's ready for multi-years, maybe even multi-decades of economic growth. India is basically where China was about 15 years ago, in terms of GDP, and as you mentioned, with a population that is now bigger, much younger, there's a lot of potential for the country. India remains really one of our favorite countries to invest in.

A lot to digest there. Moving on from the big picture to something a little more granular, what themes within EM are you and your team most excited about today, and how are you positioning your portfolios?

I would say, there are several themes because we have this thematic approach. We have identified areas of long-term secular growth, but to highlight a couple at the moment, and just on what I was mentioning before, I think domestic consumption has always been a big theme in emerging markets; I think over the next few years, especially what I said about China, and what we see in India, where you've got this massive middle class growing very fast, we're still seeing that domestic consumption is going to be a major driver of growth for the coming years, and we want to be exposed to that.

There are many different angles, but there's the emergence of local brands, for instance, which are really interesting. When a country is quite poor and starts to develop, usually foreign brands, multinationals that tend to be in the country and are quite successful, they're an aspiration for a local population. As the country matures, you see the emergence of local brands that can cater better to the local taste, and we see that at the moment in those countries. We want to have exposure to those themes.

In China, we want to have people really very willing to spend also. As I said, they save a lot at the moment, but they still want to spend on going out, eating out, traveling etc, and have got exposure as well. Another theme which is really interesting in the emerging markets is what we call financialisation. It's just to say that in the emerging markets, in many countries, the banking penetration is very low. Right now, with the interest rates being higher, a lot of the banks in the emerging markets are doing really well in terms of returns, but there's also quite a lot of growth. We see, again, with this increase of the middle class really, a big growth in banking penetration.

There are a few countries where we see a lot of potential, for instance, Mexico, which is really one of the most unbanked countries in the world, where really more than half of the population doesn't even have a bank account. You can imagine the potential in this country. I would say that those are two of the themes we really like. If I can mention a third one, it's digitalisation, which also in emerging markets is going really fast. India, one of the reasons for the success in India is that they completely digitalised the economy at a fast speed, and that's really paying off now.

Some really interesting themes there. Moving on to the actual investors themselves now. For several years, we've seen institutional investors increase their exposure to EM equities, whereas retail investors have been reducing theirs. Given you manage money on behalf of both types of investor, can you share any insights into how different clients are thinking about their EM allocations?

Yes, I think you're absolutely right. I think speaking to the two types of clients, we have a very different conversation with those clients. Institutional investors tend to have a longer-term horizon that rarely look very short-term. They tend to have an allocation that they follow for the next 5, 10 years, and those ones are increasing their allocation to emerging markets. We've seen some interest, they tend to look at really the long-term trends such as the ones I mentioned, and maybe ignore a little bit more the very short-term volatility, when obviously retail investors are the other way around.

They're very worried about the short-term movements. They don't like the underperformance. What we've seen, we've seen indeed a lot of retail investors reducing or even completely removing any allocation to emerging markets. What is interesting right now is that we feel like after several years of seeing this trend, we feel like we're quite close to a capitulation level, which is really important. Emerging markets trade really at the lowest valuation compared to developed markets that we've ever seen, at a time when we feel fundamentals are really improving, as I mentioned at the very beginning.

We're in a period where we have higher interest rates, higher inflation. This is an environment that emerging markets can face in a better way because it's a normal environment for them. The debt level is much lower, and they've seen that many times before and that's why they also increase interest rates so early on in this cycle of inflation. Despite having stronger fundamentals on EM, we've seen the worst valuation. Disconnect cannot last for too long, and once indeed we've seen this capitulation happening, which feels like that especially during the summer where we had massive outflows of the asset class from retail investors, I think we'll be ready for rebound at some point.

Great. Let's move on to something that's really in focus, particularly in Europe, ESG. It's become a major focus over here now. Emerging markets would on first sight appear to offer considerable challenges in this area. Your fund is well known for the way you integrate ESG into its investment process. Could you shed some light on the main challenges you experience and how you navigate them as an investor?

Yes, you're right. It's a huge focus as well on the emerging markets and as you mentioned for us, we always integrated in our process simply because it's emerging markets. In emerging markets, I guess it was more on the ‘G’ of ESG for a very long time but the ‘G’, the corporate governance which is so important is there's a huge range of quality of corporate governance in emerging markets. For us, we always included it because obviously we want to avoid the companies with poor corporate governance, and instead being positioned in companies with the best corporate governance. Otherwise, you're exposed to companies that we feel are poor quality.

For us, it's a way of judging the quality of the company. Now, because we've done it for so long, we have our own process, we completely integrate it through our team. The challenge for emerging market investors is that, the databases, the information that is available is not great for emerging markets for all sorts of reasons. It's a very deep market, lots of different countries, a lot of smaller companies etc. Anyway, you have to do the work on your own and we have years of experience of engaging with management. We have lots of tools to do that.

We have a checklist where we include all those ESG elements and I would say that really paid off. Again, what I want to stress in emerging markets, you have to do really the work yourself, engaging, getting to know really well the management, be able to ask all those questions because you won't find the information anywhere else, basically.

Yes, I can see that and it's really interesting to learn how you as investors actually take on that challenge. Talking about challenges, I guess one of the biggest ones out there, we're always asked to look forward as investors, is how are you dealing with the latest emerging technology, Artificial Intelligence? Which countries and industries are likely to be the winners and the losers? At the end of the day, will it upend their export-led growth models?

AI is interesting because I think a lot of investors are focused and understandably to Nvidia, for instance, or the companies in the US. EM and especially Korea and Taiwan are actually very much involved into the AI trend or revolution, as you can call it. A lot of suppliers to the American players in that field are actually in Korea and Taiwan. They tend to be really high-quality companies that have invested a lot in R&D over the past few years, which means they've got high barriers to entry. They are usually one, two or three players maximum that can supply to the American companies.

That makes them quite an interesting investment, quite profitable, high growth. What is more important as well is that you buy them at a valuation which is a fraction of the American players. We think Korea and Taiwan are really two great ways of playing the AI revolution. Actually, when people think about emerging markets, and I mentioned at the beginning, yes, they think about domestic consumption, they think about commodities, but there's a lot more. The composition of the companies in emerging markets has evolved a lot over the past few years. You actually have a good chunk of the benchmark and the portfolios that are exposed to more for digitalisation, I mentioned, including AI.

I think that's interesting to remind people that Korea and Taiwan are part of the emerging markets indices. I think a lot of people forget that. Anyway, it's clear that the ever-evolving political, social and economic landscape makes this a hugely compelling and interesting asset class. I'm sure that 2024 will continue to bring a wealth of discussion points. Thank you, Laurence. I hope you can come back on the show next year.

Thank you very much.

I hope you've enjoyed today's show. Please like and subscribe on your podcast platform of choice. We will be back next month when we will be moving to the other end of the investment universe as we will be joined by Kasper Hense from our investment grade team. Thank you very much for listening, goodbye.