Investors are reducing their exposure to emerging markets (EMs) despite positive growth signals, leaving plenty of opportunity for those that can buy in to companies at discounted prices, said Andrew Ness, portfolio manager of the Templeton Emerging Markets Sustainability Fund at Franklin Templeton.

Here, Ness discusses how investment in EMs is changing on the back of the global transition towards a cleaner future, and in what ways it can drive future fund growth.

Emerging markets have traditionally been seen as more risky to invest in. Has that outlook changed, or have asset managers become more willing to take risk with their investments with regards to emerging markets?

The historic volatility of EMs is higher than that observed in developed markets (DM): 21 versus 15, based on Franklin Templeton’s capital market expectations. The higher volatility in EMs reflects lower, albeit improving corporate governance, higher inflation and larger drawdowns compared to DMs.

EMs, by definition, are likely to remain riskier than DMs. Part of this is due to classification. As EMs mature and are upgraded to DM status, they are replaced by less mature, fast growing but riskier EMs. Nevertheless, over the past 20 years, we have observed improving corporate governance, a structural decline in inflation and shallower drawdowns. This has led to lower volatility and a reduction in actual risk in EM.

The perception of EM risk has, however, lagged this new reality. In recent years investors have been reducing their allocation to EMs. This is despite better growth, access to some of the fastest growing industrial supply chains in the electric transportation industry and opportunities created by growth in middle class consumption.

What is the role of the global energy/social/financial transition in changing this way of thinking?

There is a rigorous global effort to tackle perennial challenges such as poverty, inequality, climate change, environmental pollution and resource scarcity. This was established in 2015 with the launch by the UN General Assembly of its 17 UN Sustainable Development Goals (SDGs), plus 169 underlying targets.

The timetable for the UN SDGs is an ambitious one: it’s hoped that all goals will be achieved by 2030, with progress subject to annual monitoring. But meeting the UN SDGs in this timeframe presents a significant funding gap that can’t be met by government spending alone, especially in lower-income economies. That gives rise to a major financing role for private capital – and therefore a significant opportunity for investors.

According to the IEA, the world’s energy and climate future is becoming increasingly dependent on decisions made in emerging and developing economies. Annual public and private investment in clean energy in emerging and developing economies must more than triple from $770bn in 2022 to as much as $2.8trn by the early 2030s, staying around these levels until 2050.

There is an opportunity to design a new, lower-emissions route for growth and prosperity thanks to the declining cost of essential clean energy technologies. However, the potential for the clean energy transition to fail in these nations will be a major source of contention in the global effort to combat climate change and achieve sustainable development objectives. Therein lies the opportunity. With the SDG funding gap, private capital is needed for companies providing transition-related solutions.

We continue to find many opportunities across our markets, not just for direct investments in renewables or electric vehicles but across the supply chain. Advancements in technology that drive improved battery energy density and increased solar panel conversion efficiency have been of particular importance, and we find many of the leading companies in these spaces to be in EMs.

What opportunities are there in emerging markets that hadn’t existed previously?

Some of the most exciting and high growth investment opportunities globally are to be found in emerging markets. Opportunities include the electrification of transportation and the supporting supply chain, consumption and digitalisation. MSCI Emerging Market index trades on an attractive price-to-earnings ratio of 11x compared to a historical average of 12x.

There is, however, currently an absence of clear catalysts to re-ignite investor enthusiasm for EMs. Nevertheless, there are country specific exceptions including India and Mexico, and more recently Taiwan and South Korea.

In what ways could emerging markets drive future growth for a fund?

Scale. The funding needed to meet the UN SDGs is greater in emerging markets. In 2014 the UN estimated $4.5trn annual funding through 2030 (versus $2.5tn for developed markets).

Emerging markets are under owned relative to the Index and the past. Investors’ allocation to emerging markets are 5.6% versus 11.6% in 2012. Additionally, they’re underestimated and undervalued relative to developed markets, where debt is higher: 108% of GDP versus 66% of GDP in emerging markets, with an MSCI EM of roughly 47% price to book discount versus MSCI World.

Buying fast growing companies in emerging markets at a discount to our assessment of their intrinsic worth is the best way to grow the value of the fund over the longer term.

What new challenges do you expect to emerge from this increased focus on emerging markets?

Emerging markets have been buffeted by a number of head winds in recent years, ranging from Covid-19, defaults in the Chinese property market and a slump in the semi-conductor industry. While we cannot forecast the unknown, we believe that market valuations reflect a considerable amount of bad news and there is more upside than downside potential for markets at current levels.