Locals should drive small EM and FM equities, a salvation for foreign survivors
- Small EM and FM equities cheap relative to their history, but foreign funds too small or distracted to take advantage
- But local investors should be tempted by dividend yields that are competitive with local currency government bond yields
- Those foreigners who have survived the redemption apocalypse should be rewarded for their patience and resilience
Few foreigners like or still look at small emerging and frontier markets. The same cannot be said for local investors.
In a number of small EM and FM equity markets, equity dividend yield is attractive relative to real interest rates and local currency government bond yields (ie these markets look attractive without incorporating the prospect of share price appreciation). Therefore, local investors should drive local equity markets.
This could provide some salvation to those few, generally very small, foreign institutional funds dedicated to these markets, which have survived the redemption apocalypse.
Local investors' renewed interest
Local investors in small EM and FM markets are generally made up of "retail" (more high net worth individuals and quasi-family offices rather than the moms and pops associated with retail in developed or the largest emerging markets), quasi-government (eg sovereign wealth), and local banks, rather than local institutional investors (Morocco and LatAm markets are exceptions).
These investors are driven not just by the same "animal spirits" seen everywhere else but also by the short-term returns on offer in equities relative to liquid alternatives like bank deposits and government securities. This trade-off could be summarised by comparing, where the data allows, real interest rates, annualised yields on 5-year local currency government bonds and 1-year forward equity dividend yield. (In one way, this is a very punitive comparison for equities because it completely excludes the prospects of capital appreciation.)
An additional driver for more local investment in local stock markets, compared to five or ten years ago, is the more prohibitive regulation (anti-money laundering), which should result in a higher proportion of local wealth being retained in country.
Foreign investors have evacuated
Activity by local investors far outweighs that of foreign investors in most small EM and FM equity markets (by a factor of 7-9x in markets like Vietnam or Pakistan in Asia, less so in Africa, and least in LatAm).
But over the last ten years there have been periods when foreigners have acted as the largest marginal buyer (during periods of fund assets under management growth) or seller (during redemptions) of particular stocks; eg those with large index weights (and, usually, greater trading liquidity), or those included in foreign benchmark indices like MSCI EM, FEM, or FM, or those which were "discovered" by foreigners managing active funds, eg Mobile World Group in Vietnam or Hightech Payment Systems in Morocco, or large IPOs, eg Habib Bank in Pakistan. However, four factors have marginalised foreign investors over the last five or six years:
The concentration of the MSCI EM index into a small number of countries (Brazil, China-HK, India, Korea, Taiwan, and South Africa now make up c85% of the index) means that there is a long list of over 20 countries that are too small to make a difference to performance for most EM-benchmarked funds, and this is before the over 20 countries in FM or classified as standalone;
The collapse of assets under managements in dedicated FM funds has meant that, in some cases, individual funds are no longer of sufficient size to move share prices in local markets (dedicated active and passive assets under management, benchmarked to the FM index, have shrunk from a peak of cUS$25bn to well under US$10bn, according to EPFR).
The consensus rush for Technology exposure, which has not only exacerbated the concentration of the EM index in China-HK (Tech applications) and Korea-Taiwan (Tech hardware) but also led investors in small EM and FM to focus their holdings away from existing commodity, financial, and consumer sectors to internationally listed Tech (eg Delivery Hero, Falabella, Jumia, Mercado Libre, Opera, Sea, Yandex, and, more recently Allegro, Kaspi, and Yalla).
Currency crises, eg in Argentina (twice), Egypt, Ghana, Kazakhstan, Lebanon, Nigeria (twice), Zimbabwe, have led to the bitter experience of trapped capital and prompted more foreigners to focus on existing international listings, eg Centamin, Commercial International Bank, Halyk Bank, LatAm ADRs, or new IPOs on international exchanges, eg ASA Intl, Helios Towers, Kazatomprom, Network Intl, Seplat Petroleum, Vivo Energy.
This marginalisation obviously does not stop those foreigners who have survived the redemption apocalypse in small EM and FM from benefiting from a re-rating of local equity markets by local investors.
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