Fintech on Friday: Emerging markets becoming centres of innovation

Not long ago, emerging market investing was all about commodities, with extractive industries dominating the index. But as technology has transformed developed markets, it is also having an impact around the globe.

Of course, emerging markets have had technology companies for a while, but where these were once derided as copycats, taking ideas developed in Japan or the West and knocking out cheaper versions, or with the countries themselves seen as a source of cheap labour for global companies, the picture is changing.

New player in town

“Silicon Valley’s dominance of global tech is under threat,” says Luca Paolini, chief strategist at Pictet Asset Management, explaining how emerging nations are becoming better innovators than their developed market counterparts.

“Emerging economies are no longer content to be limited to assembling American-designed and developed components. Increasingly, they will create the intellectual property that runs the world.”

This could be a great opportunity for investors, believes Mr Paolini. Emerging market tech companies’ earnings are expected to grow 22 per cent over next three to five years, he explains, outpacing the 16 per cent expected from their developed-market counterparts.

“Today’s emerging markets lie at the forefront of the latest technological developments, from mobile banking and shopping to robotics, autonomous vehicles, healthcare and more,” says Chetan Sehgal, lead portfolio manager of the Templeton Emerging Market Trust.

Developing countries are often able to capitalise on technology more quickly than more advanced countries, he explains. “A technological ‘leapfrogging’ enables the adoption of new technologies that bypass legacy models or systems,” says Mr Sehgal, giving the example of the rapid adoption of mobile payment systems in Africa, bypassing the building of physical bank branches.

China is leading the way though, he claims, be it through the development of the world’s most powerful supercomputer or taking the lead in the autonomous vehicle race.

“Self-driving vehicles are one of the key sectors in the Chinese government’s ‘Made in China 2025’ initiative, which encourages collaboration between Chinese technology companies in all aspects of development,” he explains. For example, in December 2017, the Beijing Municipal Transport Commission granted approval for testing self-driving vehicles under certain conditions.

Wave of disruption

Just as the disruption of traditional industries transforming developed economies, this is also a major theme in emerging markets, explains Hou Wey Fook, chief investment officer at DBS Bank in Singapore.

“The internet is changing the way people live and work,” he says. “The implication of this structural shift is huge. We see major disruptions unfolding in the retail space and further gains in e-commerce, as has already happened in the US.”

To gain exposure to this theme, Mr Hou suggests looking at Chinese internet companies, which are already very dominant in their home market and are increasingly looking to diversify to other parts of Asia.

China is also becoming a superpower when it comes to the development of Artificial Intelligence.

To develop AI, you need the technology, the capital, a large pool of internet users and a regulatory framework, and China has all of these, explains Eastspring Investment’s chief investment officer, Virginie Maisonneuve. “Indeed, increasing regulation in the West, especially around the use of data, will give China even more of an advantage.”

The US and China are the global leaders when it comes to AI, she believes, and predicts that other nations will have to align with one or the other.

“AI is going to touch everybody and whoever controls AI will control the world,” she warns. “I have talked about digital warfare for years, and I think the current trade wars between China and the US are all a part of this.”

Shaking up the index

The rise of tech firms has radically changed the make-up of the benchmark. Tech firms now make up 27 per cent of the MSCI EM equity index, the biggest single sector, compared to 10 per cent a decade ago. Commodity-related stocks are now just 15 per cent, down from 37 per cent a decade ago.

Emerging market tech is dominated by China, Korea and Taiwan, and has been a favoured sector in recent times, delivering a 61 per cent return in 2017 – versus the broader index’s 37.7 per cent. But have investors missed the boat?

“Valuations in many parts of the sector appear rich and investors have been taking profits, leaving it generally underweight relative to the index at this point,” says Kathrine Husvaeg, senior portfolio manager at Russell Investments.

Indeed not all investors believe it is necessary to play the tech theme to do well in emerging markets.

“We have done well without riding the big tech trade,” says Raheel Altaff, co-manager of the Artemis Global Emerging Markets Fund.

The Artemis strategy is to look for opportunities within “unloved” parts of the market, for example utility companies in Asia. “Tech is a ‘hot’ area where we have much less exposure. It is a crowded trade,” adds Mr Altaff.