BPM Talk

David Kitai   0:09
Emerging markets are not one big investment bucket anymore. You could argue that they never were for the past few years we have seen a significant shift in the nature and pace of globalization, the rise of friend shoring and onshoring, and a significant pullback in the Chinese economy, which had been such a driver for EM investors for almost 20 years. All these changing circumstances are demanding a new approach to asset management.

Hello and welcome to this special edition of the BPM Talk podcast where we are exploring the idea of single country investing, a discipline that seeks to capture opportunities as they arise in specific markets without tethering to the risks associated with a broader emerging market or regional index.
To unpack this approach and explain why it may be relevant today we are lucky to be joined by David Jones, director of the iShares investment strategy at BlackRock, and Rohit Gupta, VP and quantitative researcher at MSCI. Gentlemen, welcome to the podcast.

Jones, David   1:06
Thank you.

Gupta, Rohit   1:07
Thank you, David.

David Kitai   1:08
So let's just start with my own novice knowledge. Educate me here. What is single country investing and why does this approach require a bit of reimagining?

Jones, David   1:20
So you can imagine, you know, single country investing as really just kind of slicing up the larger index pie to implement specific investment views. It's an investment asset allocation decision and it very much like something that you can do in equities where you move from large cap to large cap technology and get a little more specific and focus on the parts of the market that you think are going to return the most value the same way you can do that in global equities. You can go from regions to single country and a lot of investors are starting to do this now, right. I think you know, conceptually, we tend to think as investment as you know, EM versus DM, emerging markets versus developed markets. But when you use big groupings like that, that can confound a lot of the value that you're trying to get from that kind of grouping. And merging markets are not a monolith, right?
There's a lot of complexity. There's a lot of differentiation within them. There's a high degree of differentiation due to, you know, different central bank policies, different fiscal positions, different external sector exposures, GDP makeup. You know, there's a lot of things that go in there and they just lump it all together. You begin to lose some of the, you know, factors that return value by mixing it with other things.
So, you know, putting an overweight or underweight on particular countries can be a way to add differentiation and add outflow to a portfolio. And I can give you a few examples if you have time for that.

David Kitai   2:52
Yeah, for sure. Quickly and anything Rohit, you'd like to add on the on the broad nature of single country investing before we get into some of those examples.

Gupta, Rohit   2:59
Yeah, definitely. I think broadly agree with David mentioned like in a layman's term, single country investing basically enables investors to focus their exposures on specific country markets which in their views they think that might return with favourable risk return characteristics.
And as David you mentioned like why does this approach would require reimagining right now.
So some of those you also mentioned that the current macroeconomic landscape it is being marked by a lot of geopolitical tensions and the rewiring of supply chains with asset allocators and investors pulling out of China. So, all these things are basically creating opportunities for single country investing where investors are looking for international diversification. They are looking for growth opportunities. They are increasingly seeking to integrate their sustainable investment objectives and at the same time they also manage their risk efficiently and these four things are at the top of the mind of many of these investors and that's why at MSCI as well, we proposed a framework that incorporates all these important tenants of country and market allocations.

David Kitai   4:15
Hmm. OK, David, let's go with a few examples here. but can you demonstrate just a few instances where single country investing can sort of be applied?

Jones, David   4:24
Sure. I think you know the most obvious example and the one that's really top of a lot of investors might minds right now is the, the China, India sort of example, right? China was the last decades EM growth story. You know, just a just a historic success really, when you think of the terms of economic development and as well as just the growth of the capital markets. But now it's trying to sort of eke out a 5% GDP growth. There are a lot of questions about the, you know, macro framework, particularly with the with the real estate overhang, some deflationary issues and aging population. And so, China, which makes up a very large part of many EM indices, is actually seen this favourably by a large number of a large number of investors. There's also geopolitical risk associated with China. So, you know, we have seen some investor investors interest in emerging markets, but a lot of caution on China. So, you know you can contrast, you know, the role of China within these indices with another country like India, which, you know, another large, populous country. It looks in some ways like China. Did you know? 15, 20 years ago, right. It's got 7% GDP growth, solid fundamentals, reasonable inflation. It is a beneficiary of geopolitical fragmentation. Whereas China was a beneficiary of sort of globalization, you have GDP driven by foreign investment, a growing young population. There's a lot to like about India. So, you know, when you go in sort of a single country or a focus on single country, what we're seeing is the trend is people tending to underweight China and overweight India.

David Kitai   6:10
Hmm. OK, oh please Rohit.

Gupta, Rohit   6:14
Yeah. I mean, as David mentioned, like it's the EM growth story where people where investors were earlier looking at China and now, they're looking at India. So given the four important tenants that I just mentioned, the growth opportunities is something what investors are looking at and it is not just the economic growth of the GDP growth that investors should be focused on. So, there are other important factors in datasets. For example, investors could also look at thematic investing.
They could look at the economic exposures of countries. They could look at sector exposures of countries. For instance, if we look at the constituents of MSCI Canada, it has more than 50% of its revenues linked to international sources, including the US and some of these. Some of these revenues would also be looked attached to some of the growth opportunities as well. And these inputs might have a lot of implications for global investors and could be useful while doing the asset allocation in terms of sustainable investment objectives, investors could look at low carbon transition dataset which might help them choose winners and losers in terms of single countries and for managing their risk. I believe there are a lot of macroeconomic indicators as well which would be useful for investors while managing their risk effectively.

David Kitai   7:43
Hmm, so this is just a little bit of an organic follow up. But maybe we can do this as a very brief answer. It seems single country seems very common sense to me. You know you wouldn't just look at, you know, the broad wider world or even a bucket as wide as emerging markets if you were, if you were trying to achieve sort of targeted results in your investments, why is this somehow the new the more novel approach as opposed to one where you're just going to lump a whole bunch of different geographies and risk factors and growth trends altogether into one big bucket? But why is this not sort of... Why is this newer?

Gupta, Rohit   8:20
Uh, well, overall, I think this is a question of how country level diversification makes sense.
And I think the core principle underlying global diversification is that economic cycles and all these geopolitical risk and market specific events, they affect individual countries and regions in different ways and at different times and hence all this country level diversification or international diversification, it's value to a global diversified portfolio because overall it reduces the impact of any specific market related event. Thereby, it might be useful in enhancing the long-term returns for the investors.

Jones, David   9:06
Yeah. And just to add on that, I don't think it's necessarily new, it's more popular we have had country specific ETFs for instance for 20 plus years. But what we're seeing is just the overall development of a lot of emerging market countries. Countries like Brazil, countries like India and you're starting to see the growth of their capital markets and the increasing diversity of their capital markets. You know, these countries are no longer just dominated by a single oil producer or a single minor. Now you have consumer discretionary. You have banks, you have industrials of all sorts. So, the countries have become more complex, their economies are more diversified. And so, there's just a lot more, you know, of an investable opportunity there. And I think that's why you're seeing more of a focus on single country.

David Kitai   9:55
Hmm. OK, so now we have a good picture of a single country. How can single country market views be applied to portfolios by asset managers?

Jones, David   10:07
Well, there you know there. There are two ways, or I guess 2 flavors you can call it of expressing country specific market views and I guess you would lump them into the categories of either managing risk or capitalizing on specific opportunities. I think an example of managing risk is one that I touched upon earlier with the China situation. You know, there are a lot of questions about the direction of China, about global fragmentation, about the real estate overhang and some of the nonperforming loans on the books of Chinese banks and local governments. And so, what we're seeing is, you know, a trend in the flows towards emerging markets ex China. So, there are almost like a negative single country view, right? You have the entire emerging market portfolio and then you just exclude a single country and there you know, so there you can invest in sort of broad EM return factors. But void the risks that you think are specific or unique to one country. I think you know there's also sort of capitalizing on opportunities. The second category, and there you're looking at countries you know you can just put a specific overweight on either India for the reasons that we mentioned. You know, Mexico is another one that people are broadly interested in in terms of long-term tailwinds about reshoring, about bringing industries back from Asia, bringing them closer to the US supply chain, and in a more sort of politically friendly sort of governance. Those are the sort of ways that I think you can look at country specific market views and portfolios.

Gupta, Rohit   11:44
Yeah, I mean just to add, like David covered a lot of it and to add to that perspective like we have observed and we have bucketed into three typical approaches and David covered like the first approach is sort of a tactical allocation, which we may say where investment managers would have would dedicate a particular portion of their portfolio in order to exploit a specific country or market opportunity. And as David mentioned, let's say investors, they are very of their risk in China and they're excluding it because of those risk or maybe, let's say an investor have a very positive views of bullish views on Indian equity markets. So, there might be overweighing that particular market.
The second approach that we find is sort of a portfolio completion approach where let's say an investor is benchmarked to MSCI emerging markets and might not have any weight in a particular country, let's say, India. And they're hugely underweight India. So, at that point of time, they might be targeting a particular market which is underrepresented in their current portfolio.
And let's say they would add a dedicated India strategy in order to be aligned with the benchmark.
And lastly, what we have observed is more of an active management strategy, which is a country rotation sort of an approach where investors might be coming in and out of a particular country based on their views on various factors and signals. These could be, let's say, fundamental views, or could be some sort of momentum or trend following sort of strategies.

David Kitai   13:14
OK, So, what are some of the unique contributions that country level diversification can bring to a globally diversified portfolio and does the contribution differ when we're looking at a developed country or an emerging market country?

Jones, David   13:31
Yeah, I would. I would say the contribution differs markedly from developed and there were doing market countries, and you know and painting a broad brush here. But you know what? You what you tend to see is that in developed markets, factor exposures tend to be more range bound than emerging markets. Developed market countries tend to be synced and tend to move together.
They have, you know, they're all fairly complex economies and complex markets. So, if you were to look broadly at, you know, France, the UK or Japan and kind of, you'll see that they all have, for instance, now they have sort of a negative well, the exposure in terms of their factors.
And you know where they differ is, you know, to the degree in which they have negative volatility exposures. You know, contrast that with emerging markets like India and Mexico that have a negative volatility exposure. While countries like China and Brazil, towards volatility, you know, to a significant degree. So what you see is that the you know emerging markets because they are less developed because they tend to have more concentrations because there's more diversity. What you'll see is that there different factors that that drive their performance, and so the there is a contribution difference for developed versus emerging markets and you know I guess I got ahead of myself, maybe I should go back a little bit and describe what I mean by factors. Factors are things that are you can almost think of it as like a like in a PCA analysis, right? Something that drives sort of broad categories that drive return things like value, things like profitability, things like minimum volatility, things like, you know, the size market capitalization of different constituents, right. There are sort of broad categories that tend to move in and out of the significance of explaining performance, and that's true within regions, little countries, and they can vary widely in and remain persistent.
So you know, when you look from a factor perspective, these sort of commonalities that drive performance, what you do see right is that you know a small, a small shift in the weightings between these factors can really have a meaningful impact on portfolio outcomes relative to a benchmark.
And that is even more true with an emerging market than it is within developed markets.

David Kitai   15:56
Rohit, anything you want to add on that one?

Gupta, Rohit   15:59
Yeah, my, I think from the MSCI point of view we have a different take, slightly measuring it in a different way. So, we look at, we look at the return dispersion or we have a measure which we call it as cross- sectional volatility. And this cross-sectional volatility or CSV? It could be decomposed into two components, which is the factor group component and the specific component. So, both of these components have their implications in terms of a budgeting risk for both top-down and bottom-up allocations. So here given we are talking about contributions for developed and emerging markets and also looking at single country investing. So top-down allocations make a lot of sense to discuss over here and that's why if we look at the contributions from some of these factor groups to cross sectional volatility and these factor groups, as David mentioned, some of these like styles could be individual markets and industry. So these are the three components of these factor groups. What we found that in developed markets overall, these style factors in industries have made a higher contribution to the cross-sectional volatility over the past decade. So, this means that style factors in industries plays a major role in terms of the return dispersion in developed markets. But in emerging markets, contributions from individual markets or countries they have dominated throughout history, now what does this mean? Is that diversification across countries within emerging markets, they are one of the most important criterias for diversifying risk within such markets and also produces alpha generation opportunities in emerging markets.

David Kitai   17:52
Hmm. OK, fantastic. Now, we painted a pretty positive picture here, but every investment strategy comes with risks. So, what are some of the risks associated with single country investing?

Gupta, Rohit   18:04
So some of the major macroeconomic risks that are on the horizon today and we keep on hearing them day in and day out; first is inflation. Then there are concerns around fiscal imbalances.
And then we have touched briefly till now about trade tensions as well because of lot of geopolitical tensions that's that have emerged. So we need to understand that these risk, they have different implications for both the developed and emerging markets, because each economy would have a different economic structure, they would have some sort of different response to their policies and many countries within these markets would have varying sort of external vulnerability as well, given that inflation is at the top of mind at everyone's mind. Let's take a look at inflation first. Inflation has been posing a bigger challenge for emerging markets compared to developed markets over a long period of time. And well, some of the reasons that are responsible for that because emerging markets have had historically volatile inflation rates, they tend to have less credible central banks which manage these interest rates tend to control inflation and also, they have relatively weaker exchange rates compared to the US dollar.
So IMF has forecasted that the inflation rates for emerging markets compared to developed markets would continue to be high for the next five years, although it would be at a lower level compared to what we have seen historically. Now on the other hand, fiscal imbalances is something that may be problematic for developed economies now, as compared to emerging economies, because many developed markets, including US, have accumulated very high levels of debt. And some of these developed economies, they also face relatively low growth prospects, and some have witnessed sort of recessions as well in the last one or two years. That's the reason that maybe IMF has forecasted that estimates of debt as a percentage of GDP for these developed markets would be more than 100% compared to emerging markets, which would have significantly lower debt levels over the next five years. And the third risk that I highlighted, it's like looking at the trade tensions, which might have different exposures to EM in the PM because of how they supply chains, is got a rewiring right. So, for that, we looked at the trade balances and the trade gap between emerging and developed markets. So, this trade gap over the past few years, it has largely narrowed down some of the reasons for this narrowing of trade gap is because it has been increasing focus on higher domestic consumption in the emerging markets coupled with what we saw and we've discussed is the strengthening of the deglobalization trend.
And IMF forecast that the narrowing for these trade gaps would continue between emerging and developed markets for the next five years. So overall, these are some of the major macroeconomic risk indicators, which I guess investors should be looking out when they're looking at emerging and developed economies.

David Kitai   21:38
OK, that's great. And that's very comprehensive. Thank you. David, anything you want to add there on the risks in this space?

Jones, David   21:46
Yeah, I think you know Rohit covered most of that. I think one thing to keep in mind, you know, particularly with with EM investing is that emerging markets are largely prisoners. You could say of, you know, U.S. policy in a way, right? The US policy matters enormously for these emerging market countries. They can have great fundamentals, but ultimately what the US does almost matters more in many respects. You know, when it comes to investments. So, for instance, a lot of Latin American countries run a current account deficits, meeting that they're investing and consuming more than they're saving. I mean, that's a natural position for a lot of, you know, quickly growing developing countries. But it also means they have to attract capital from overseas. So how do countries like Chile or Colombia? How do they attract capital in instead of having that capital go to the US, they have to offer higher rates and if they don't offer higher rates then capital flows out of the country, the currency weakens and. And so, what you find is like, even in in places like Brazil, which had good fundamentals, they have very high interest rates relative to their inflation and it's choking off growth. And they would love nothing more than to be able to cut rates, but they simply can't, because US rates are where they are. So I think you know the last risk factor is not even EM specific. It is really just, you know, U.S. policy and how that impacts EM's?

Gupta, Rohit   23:16
Yeah, I mean I cannot agree more with what David mentioned. Like many emerging markets, including India as well, they mostly are in a wait and what sort of a scenario guided by the US policy rates, in order to think with any of their existing policy rates.

David Kitai   23:33
It's always fascinating, and whenever I talk about capital markets, no matter how far flung or how, how you guys would have far out in the world, do you think it is, it always comes back to U.S.
Policy. So, this there's always the tie back to the states. So just in some ways it's a bit of a final question. How can investors gain exposure to some of the structural changes in businesses and economies that you've kind of highlighted through thematic investing approaches?

Gupta, Rohit   24:01
I think we briefly discussed this initially that investors looking at growth prospects, they shouldn't be just focused on economic growth, but there are other factors as well, like they could look at innovation, market stability, technological advancement. So thematic investing is also a way of gaining exposure to structural changes in businesses and economies that are driven by, let's say, long term friends and by these long-term trends, MSCI has identified 4 mega train categories.
So the first would be environment and resources, transformative technologies, health and healthcare, and society in lifestyle. So, this entire framework bucketed into these four mega train categories could be thought of as, let's say, complementary to a more traditional sector in industry scheme, such as the gigs. But I think the question that comes is how growth could be achieved using thematic investing so. We looked at this analysis and what we did is like we had some 28 MSCI thematic indexes and we segregated it and looked at the regional distribution of companies within these thematic indexes. So actually, like let's say, what countries are the major proportion of these thematic indexes? What we found broadly is that many of these firms or teams, I would rather say they are strongly represented by the US and Chinese firms, which is which is not, should not be a surprise because we all are aware like how the magnificent 7 or AI related companies, they have been dominating a lot of returns quite recently. But when we did a deeper dive into these investment opportunities, we found that, actually there are many firms and there are opportunities that exist beyond US and China as well. So let me take an example over here. We have a MSCI acquired robotics and AI index and what we found that in this index 40% of the artificial intelligence firms are vortex and air forms. They are outside US and China. 40% is a big number, right?
So we found that there are markets which may include like Israel, Korea, Switzerland and Taiwan.
These are bucketed as sort of brought innovators and these markets actually display diverse exposure to various themes, including the recently dominating artificial intelligence themes.

Jones, David   26:55
Yeah, I would. I would add just very briefly. You know, we're regarding thematic investing.
We're seeing, you know, two key trends in this respect. And I think the first one is the idea of, you know, global geopolitical fragmentation. You know this, this is this is the story that we've we trust.
We've already touched on about managing risk and capitalizing on opportunities. The reshoring that you're seeing from China to countries that are closer in terms of supply chain as well as perhaps more politically friendly to the United States, you know Mexico is one of the big beneficiaries from that, overtaking China as a as the US's largest trade partner companies moving out of China to other parts of Asia with which may have lower manufacturing and production costs, but also the benefits of perhaps political friendliness towards the United States. That is one big theme that I think investors can take advantage of. Another one is just the development of emerging markets and the stability and the verification that we're seeing there. You know, emerging markets today are not like emerging markets where 20, 25 years ago, right, they're much more stable. They have much higher reserves, they have much healthier fundamentals and they've already sort of moved up, right. You know, people, I think oftentimes have these sort of outdated notions of emerging markets that just sort of commodity producers, you know, minors, oil producers, energy. That's not what emerging markets what many emerging markets are like now, you know, they have diversify, they have, they have, you know, rather advanced financial sectors, they have industrials and services.
Just look at India, I think is a is an excellent example of, you know, sort of a country that exports services through technology and through global connectivity you you know they've had 11% growth in service exports outpacing they're good export growth and you know, professional consulting and professional services is one of the fastest, you know sectors growing in India. And when they're when they're highest export sectors as well, so that that creates, you know, opportunities within India and makes them. Yeah, you know more, you know, provides more of a buffer against sort of, you know, a commodity and supply side shocks.

David Kitai   29:22
OK. That's fantastic. And again, a comprehensive answer and some really thoughtful and worthwhile pieces of knowledge to tease out there. But unfortunately, I gotta say, after so much has been shared that that is all the time we have for today. So thank you both for joining us and and taking the time to discuss the idea of single country investing with, with myself and with all of our listeners here at BPM talk.

Jones, David   29:44
That was great. Thank you for having us.

David Kitai   29:45
Thank you. And to our listeners, you don't need to be too worried that this conversation is coming to an end because we are gonna be offering a Part 2 of this episode, exploring the opportunity sets in two countries in particular, two countries that have come up in this conversation, India and Japan.
Thank you to all of our listeners for BPM talk. I've been David Kitai. Thanks, and have a great rest of your day.