Ask the Expert with PGIM Quantitative Solutions Why emerging markets?

In this conversation with Chipo Muwowo (Head of Content, Savvy Investor), Chris Zani, CFA , FRM (Principal and Portfolio Manager) of PGIM Quantitative Solutions talks about emerging markets in more detail, touching on themes such as generative AI, the role of improving corporate governance in growing company earnings, and key sectors to watch.

What factors are responsible for the current, elongated valuation spread between emerging and developed markets?

Developed markets always trade at a premium to emerging markets for many sound economic reasons. First and foremost, it starts with shareholder protection. Investors are willing to pay a premium to know that there are rules in place to protect the return of their capital. Also, investors are willing to pay a premium to ensure their capital is allocated efficiently and effectively, which is carried out through effective boards representing the interests of shareholders.

What are the risks of developed markets outpacing the GDP growth of emerging markets due to easier access to new technologies, such as AI?

Generative AI is still a new and burgeoning technology, but one that has the potential to help companies “do more with less.” Based on that, it’s reasonable to think that countries with fewer people can close the population gap by using technology in a more effective manner. At this stage it’s still too early to project the adoption and commercialization of generative AI to narrow that gap, but it’s certainly conceivable, given its potential.

Are there any indicators or events that have typically marked the end of the four super cycles you mention in the paper?

Each inflection point has been fairly idiosyncratic. For example, the end of the previous developed market run came during the Technology, Media, and Telecommunications (TMT) crash of the late 90s/early 00s. But there hasn’t been any one common theme that can be linked. Each individual occurrence has been a confluence of events as opposed to a singular catalyst, save the bursting of the TMT bubble.

You talk about a weakening dollar having a positive correlation to the performance of emerging market equities. Do you believe the U.S. has inflation under control for the long term?

The recent reduction of the fed funds rate by the Federal Reserve seems to indicate their belief that inflation is on a downward trajectory. The data also seems to support this. However, with the recent re-election of President Trump and his expected policy of tariffs, the inflation story could possibly reverse.

“Investors are willing to pay a premium to know that there are rules in place to protect the return of their capital.”

Can you talk about any specific improvements in corporate governance that could lead to improved emerging markets performance?

The most notable examples have come from Asia, where Japan created a playbook that countries such as South Korea and China have started following. Within developed markets, Japan had historically been a laggard in protecting shareholder rights. Few corporations had independent board members and they were often run very inefficiently. The pressure to change did not come from companies or the government, but instead from financial exchanges. For example, the TSE (Tokyo Stock Exchange) threatened companies with “shaming” or delisting if they did not keep their ROE and/or price-to-book ratios above a certain threshold. There were also changes to Japan’s stewardship code to promote more independent board members. In an effort to stave off the economic stagnation experienced by Japan during its “lost decade”, both South Korea and China are proactively using these techniques to attract new capital.

How will emerging markets’ high GDP growth translate into better corporate earnings growth?

The adoption of shareholder protections and capital reforms is far from widespread and pervasive, but it’s a trend in the right direction. China and South Korea are two of the largest players in the space, but the uptick has been slow in other markets such as Taiwan and India. Brazil is even further behind in adopting reform measures.

The article continues on page 9 of our Special Report: 'Emerging markets: Growing your exposure'.