Tempora Mutantur: reflections on 30 years of global emerging markets

Your capital is at risk. Past performance is not a guide to future returns.

“In September 1981, I stood behind the lectern at Salomon Brothers HQ in New York City, preparing to pitch the idea of a ‘Third World Fund’ to a group of leading investment managers. Developing countries, we argued, enjoyed higher economic growth rates, and boasted a rich set of hitherto-ignored promising companies. Judging by the faces in the crowd, I could sense some were clearly intrigued, others were skeptical. At the conclusion of my presentation, Francis Finlay of JP Morgan remarked: ‘This is very interesting, young man, but you will never sell it using the name ‘Third World Equity Fund!’ I immediately knew he had a point.”

Antoine van Agtmael, ‘The Emerging Markets Century’

Antoine van Agtmael understood the value of marketing. No matter how sound the investment premise, it was clear that nobody in their right minds would buy the ‘Third World Equity Fund’ that he was proposing: the name reeked of stagnation, deprivation, and decline. Racking his brain that weekend, he finally came up with a far more glamorous name suggesting dynamism, progress and potential: emerging markets. An asset class was born.

Making the case for emerging markets investing has always been a bit of a struggle between the lure of superior returns and the nagging suspicion that sooner or later a disaster will come along and wipe these out. It’s a tension that’s captured in Baillie Gifford’s earliest investment forays.

Much is made in our marketing material of the very successful investments in Malaysian rubber that provided the impetus for Carlyle Gifford and Augustus Baillie to turn their Edinburgh-based legal practice into an investment firm in 1909, and which laid the foundations for the remarkable success that our first investment trust, Scottish Mortgage, has gone on to enjoy.

What tends not to get mentioned in our marketing material is our second investment trust, Scottish and Foreign, launched in February 1914 with a mandate to invest in securities in developing countries, in particular those issued by Russia’s imperial government. The timing was almost comically bad: World War One broke out within months, and with no prospect of Tsarist debt being honoured following Russia’s subsequent defeat and revolution, the trust was liquidated.

Over a century later, we can look back on our experiences in emerging markets from a much happier place. These began in earnest in the 1980s when our newly-created Far Eastern department began to dabble in the smaller Asian markets beyond Japan, and a fund dedicated to this region was launched in 1989 that we continue to run today.

By the 1990s a Latin American fund had been added to the roster, and at the same time our European department was exploring opportunities created by the collapse of Communist regimes in former Warsaw Pact countries. These capabilities finally came together in 1994 when we won our first dedicated global emerging markets (GEM) mandate and now, thirty years on, we have a client base and reputation of which we are immensely proud.¹

Yet doubts linger. Is emerging markets a triumph of marketing style over investment substance? For a start, the criteria used by index providers to delineate the universe don’t appear to make much sense: the MSCI EM Index includes some of the world’s richest countries alongside some of the poorest.

Moreover, the dirty little secret of emerging markets is just how few of them emerge. Since the launch of our first GEM product in 1994, MSCI has upgraded just three countries from emerging to developed status, and one of these (Greece) was demoted back a decade later.

The clear lesson of history is that making the transition all the way from developing to developed is extremely hard: in the last century, only a handful of countries have managed it, while others like Argentina – one of the richest countries in the world in 1920 – seem to be in permanent decline.

What about the justification for emerging market equities from the standpoint of returns? The data isn’t clear cut. From the creation of the MSCI EM index in 1988 to end of 2023, the asset class delivered a total USD return of 9% per annum against 8% per annum for the MSCI World.

However, starting points matter enormously. Much of this outperformance was generated during a single decade at the start of this century, book-ended by the crises of the late 1990s that wiped out much of the index’s initial outperformance, and the stagnation that has characterized much of the last decade.

But we think moaning about the index misses the point. Emerging markets investing is a specialist discipline in which many of the rules followed by our colleagues in developed markets don’t necessarily apply.

The ability to understand macro drivers and alignment is critical, a willingness to embrace uncertainty in the face of incomplete information is a powerful ally, and there is usually more value in backing what might be rather than what is already proven. Remember, we are investing in emerging markets, not emerging economies. It’s an approach we’ve found to be profitable from Taiwan to Turkmenistan.

Happily, there are many excellent specialist active managers in EM that have managed to handsomely augment the long-term returns delivered by the index. We would humbly like to suggest that our own track record contains some indication of a skillset that goes beyond dumb luck, and we certainly like to think we’ve been tested.

After all, this has been a period of immense change and turbulence, from the lows of the Asian crisis and the Global Financial Crisis to the highs of the tech boom or the commodity super-cycle that followed China’s integration into the World Trade Organisation. As times have changed, our portfolios have changed with them.

As we approach the 30-year anniversary of our Emerging Markets All Cap strategy – and the 20-year anniversary of our Leading Companies Strategy – we thought it might be interesting to reflect on those changes. How have we adapted, and what lessons have we learned, and – perhaps most importantly – why might the best be yet to come?

Macro matters

The honeymoon period following the inception of our All Cap strategy in 1994 wasn’t a lengthy one. We had launched a product that we hoped would allow our clients to benefit from the so-called ‘Asian miracle’ and broader opening-up of global markets. What they got instead was a crisis that began in Mexico in 1995, spread across Asia into Russia and Brazil, and briefly threatened the stability of the global financial system before the Fed reversed course in 1998.

Eighty years after the launch of Scottish and Foreign, our timing once again appeared unfortunate. Having won our first institutional GEM client in 1994, it was to be another seven years before we won our second. However, it was a product we believed in, and our performance came through the Asian crisis in relatively good shape.

After all, the basic playbook – a massive economic and asset price boom fueled by foreign capital flows that then went into reverse – was one that our investors looking at Japanese or Taiwanese equities in 1989 had experienced before.

It may have been a baptism of fire, but it hammered home a lesson that has informed our approach ever since: the importance of understanding the interplay between bottom-up fundamentals and top-down macro cycles.

Some of the investors we admire the most believe that macro doesn’t matter. We would respectfully suggest that when it comes to emerging markets, it matters a lot.

The extreme nature of cycles in emerging markets is such that there can be long periods of time when bottom-up fundamentals are completely overwhelmed by top-down factors, as investors focusing on relatively trivial movements in valuation multiples and the faux precision of earnings forecasts have found out to their cost. It’s not just the numbers to the right of the decimal point that don’t matter in emerging markets, it can be most of the numbers to the left as well.

This was evident in the Asian boom and bust of the 1990s, but it has remained an equally important lesson throughout the 2000s. This comes as a surprise to investors who continue to insist that GDP is irrelevant for equity returns; we suspect they are looking at the wrong numbers.²

Take Brazil: when expressed in real, local-currency terms, GDP growth averaged 4% per annum in the ‘golden decade’ from 2001 to 2011, and a little above zero in the decade from 2011 – 2021. This doesn’t seem an insurmountable macro swing to overcome for companies with good enough secular growth prospects.

But the number that matters for foreign investors is GDP in nominal dollar terms³: in the first period, this grew nearly five-fold thanks to a massive rise in imports relative to exports, caused by higher commodity prices, and then nearly halved in the next decade as the commodity tide receded. The corresponding boom and bust in Brazilian equities during these periods had almost nothing to do with fundamentals, and everything to do with the macro cycle.

It’s true that superior GDP growth doesn’t guarantee good equity returns. After all, investors who played the Chinese consumption boom over the last 30 years by stocking up on fine wines and the shares of European luxury brands have generally done far better than those who invested in the local stockmarket. But the headwinds and tailwinds provided by macro cycles for investors in emerging markets equities can’t be ignored, and have informed the type of growth opportunities that we look for.

Black cats and white cats

Deng Xiaoping famously said that he didn’t mind if a cat was black or white, so long as it caught mice. We’ve always felt this was quite a good way to approach investment. Our growth philosophy has remained consistent for the last 30 years: we will only invest in companies we believe capable of generating superior growth in their hard currency earnings and cash flows over the long term. However, we have always been open-minded about where this growth comes from.

We have often observed that while there is a great deal of evidence in both developed and emerging markets that a strategy of buying and holding ‘high quality’ companies (defined for simplicity as those companies with persistently superior returns on equity) can be a very profitable one, it appears that even greater rewards in emerging markets can be derived from investing in ‘improvers’ (defined as those that can transition from low to high returns on equity).

We have also observed that reversion to the mean in those returns on equity appears a much more powerful force in emerging markets than it does in developed markets. Intuitively this makes sense given the greater potential for macro cycles, commodity cycles or political caprice to dictate the fortunes of companies in emerging markets.

We have therefore always been happy to invest in such ‘improvers’ at depressed points in the cycle if the direction of travel appears positive on a five-year-plus view. Or as Dr Hans Rosling was fond of pointing out, it’s important to acknowledge that things can be both ‘bad’ and ‘better’ at the same time.

There have been periods of time when we have been happy to own more cyclical growth companies of this sort alongside our secular growers.⁴

In the early 2000s, for example, a rising macro tide was driving rapid earnings growth across large chunks of our investment universe: manufacturing exporters in Asia were enjoying the benefits of their newly competitive foreign exchange rates, commodity exporters in Latin America, Eastern Europe and Africa were seeing huge demand from a rapidly industrialising China, and these twin export drivers were turbocharged right across the region by a domestic credit cycle as banks emerged from the carnage of the late 1990s recapitalized and ready-to-lend.

During this period, our GEM portfolios had exposure to a wide range of countries and sectors right across the universe.

Conversely, there have been periods when we have been much more cautious on the outlook for cyclical growth, and our sector and country positions have been much more narrowly concentrated.

In the late 1990s, for example, large positions in the North Asian semiconductor manufacturers and the Indian IT outsourcers helped us to avoid much of the downside of the Asian crisis while capturing much of the upside of the tech boom.

While in the 2010s substantial positions in Asia’s fastest-growing internet platforms helped our portfolio to weather the macro headwinds afflicting much of our universe. Our job, after all, is not to be permanently bullish on all aspects of our asset class. It is to catch mice.

Expertise is overrated

It's reasonable to pause at this point and wonder how mere equity analysts can hope to have an edge in incorporating top-down factors into their analysis.

Very few of our team members since 1994 have joined us with any formal training in macroeconomics; our whole approach to recruitment is one that emphasizes breadth and curiosity over technical skill and experience.

And this, of course, is the point. In an industry that operates in narrowly-defined silos and is geared towards the output of spuriously precise models, our job is not to be better informed than the experts. It is to look out for potential disconnects between what the future might look like and what appears to be reflected in share prices and consensus thinking.

And where we do find inefficiencies, it’s usually a function of our time horizon. Trying to time turning points in cycles is hard: we’re happy to leave this to others.

Anticipating longer-term dynamics, however, is more straightforward: collapse is followed at some point by supply withdrawal and stimulus, which is followed at some even later point by recovery. If you have the luxury of a long-term investment horizon, it can be profitable to wait.

It's an approach that has emboldened us to take very significant bets in different countries and sectors over time, and flex these to a degree that may come as a surprise to those that know us only for our very low levels of portfolio turnover and holding periods that in many cases can be measured in decades.

We mentioned Brazil’s changing fortunes: this went from being our single largest country exposure in the late 1990s, to near-zero by the early 2010s. Today, we appear to have come full circle; it is once again our largest country overweight.

We can see something similar in our exposure to commodities.

In 2004, then-head of the Emerging Markets team, Gerald Smith wrote a paper called ‘Oil for the Lamps of China’, in which he observed that for all the detailed supply-side analysis undertaken by the experts at the International Energy Agency, they appeared to have completely missed (and indeed dismissed as a rounding error) the explosive demand coming from China. This was reflected in sell-side forecasts which anchored off spot commodity prices and mostly assumed a downward trajectory.

Our exposure to what we affectionately referred to as ‘dirty and grubby’ equities across the energy, materials and industrials sectors grew from this point, and peaked at around half of our portfolios in the mid-2000s.

Fast-forward another decade, by which time the commodity tide was firmly in retreat, and our commodity exposure had fallen to zero. By this time, it was the fast-growing tech names, semiconductor companies and internet platforms that now dominated the portfolios.

Over the last 30 years, we have made extensive use of on-the-ground expertise in the countries in which we invest, and regularly sought the advice of world-class authorities across a range of industries. But I have no doubt that if we’d tried to permanently embed such expertise within the team, it would have inhibited our ability to join the dots across different sectors and maximize our clients’ exposures to the areas that we considered to be of greatest investment interest at different points in time.

Of course, the flip side of building conviction portfolios is that there will be times when the market tells us we’re wrong. We’ve made plenty of mistakes over the years, and we’ve been through difficult periods of performance.

But we won’t stop backing our judgement where we feel we might have a differentiated view. Over the long term, the lesson of history is that our mistakes will pale into insignificance against the ones we get right.

G, S and E (in that order)

A few weeks ago, during one of our regular catchups with the CEO of a Peruvian bank that we invest in on behalf of our GEM clients, the topic of environmental, social and governance (ESG) came up. We were immediately corrected: ‘It’s not ESG. It’s GSE. In that order’.

Discussion of our approach to ESG has become a much bigger feature of interactions with clients over the last decade, but it’s always been central to our analytical task.

This much is common to all Baillie Gifford equity strategies, and reflects our long-term approach: all else equal, well-governed companies that take their environmental and social obligations seriously are likely to be rewarded with larger pools of profit and superior valuation multiples over the periods we seek to invest.

However, it’s notable that academic evidence for the relationship between ESG and financial returns appears particularly strong in emerging markets.⁵

Intuitively this makes sense, and historically has been led by the ‘G’. When investing in parts of the world where institutional strength is weaker, the rule of law a greyer area or the influence of an authoritarian regime looms larger in the economy, the odds of getting legged-over are generally assumed to be higher.

As such, it has always made sense for investors in emerging markets to think particularly hard about alignment – not just between minorities and the owners and managers of businesses, but between those business owners and the political and socioeconomic objectives of the governments of the countries in which they operate.

It has rarely made any sense to think about any of this through a western lens. How should we think about the urgent need to get to net zero in a country like India, where 400 million people still lack a low-cost, secure supply of electricity? At what point does a management team’s ability to cut-through intransigent bureaucracy become an uncomfortable euphemism for crony capitalism?

Our preference has always been to consider local context and the direction of travel in otherwise promising investments and to listen, engage, encourage and challenge accordingly. The complicating factor is that we now need to consider another layer of alignment: a geopolitical one.

The EM asset class was born in the age of neoliberalism, when everyone knew that Fukuyama’s world order was the only possible one; it was understood that as countries became richer, they would gravitate towards western models of governance. Since 2010, however, it has become increasingly clear that the world no longer agrees on the ‘right’ model, and the inconvenient truth is that the countries that have made the most economic and social progress have not been liberal democracies.

This is prompting a wholesale reassessment of what ‘responsible’ investing means in emerging markets. Any distinction investors used to feel comfortable making between good companies doing good things in countries whose values appear misaligned with their own is being shorn of its nuance.

This can be unsettling, and for a generation of investors conditioned by the unipolar world, the implications are probably only just starting to be understood. Yet disengagement doesn’t feel like an appropriate response.

Perhaps – to return to Dr Rosling – those of us in North America and Europe need to understand that we are becoming the twenty per cent, not the eighty. But whatever the new world order might look like, the idea that it does not offer a sizeable and, in many cases, vastly expanded place for many of the countries and companies in which we invest is surely wrong.

The opportunities may be bigger than anything that has gone before.

The best is yet to come?

When the case for an allocation to emerging market equities is made these days, it usually centres around relative valuation. This is reasonable enough: the asset class has gone nowhere for a decade, while developed market indices – led by those in the US – have gone from strength to strength.

It’s interesting that these valuation-based arguments are increasingly being supplemented by a new-found appreciation of emerging markets’ macroeconomic resilience. We drew attention to this in a paper in 2022, pointing out that the risk of massive capital outflows from emerging markets as interest rates rose in the US was overstated for the simple reason that there had been no capital inflows for the best part of a decade.⁶

Sure enough, we have just gone through the most aggressive Fed tightening cycle in a generation, and most of the major emerging economies have sailed through unscathed; where we are seeing any problems associated with a higher cost of capital, they are mostly in developed markets. Emerging markets, it would appear, are no longer reliant on the kindness of strangers.

But it’s the case for growth in emerging markets that we still think isn’t being discussed nearly enough. This is understandable: we are constantly told that the golden age of globalisation is at an end, and that emerging markets – as the biggest prior beneficiaries of this trend – will be the most challenged by its reversal.

Yet what we are seeing is not de-globalisation, but de-Sinification as the west seeks to grind China out of its system. There will be winners elsewhere in emerging markets as supply chains are re-tooled and capital flows re-routed; no wonder equities in Mexico, South Korea, Vietnam and India are finally attracting more attention after a decade of neglect.

Indeed, if we contemplate the key challenges we are likely to face in coming decades – the search for critical minerals to build the renewable transition, semiconductors to power the digital age, steel and cement to construct the new supply chains – it seems to us that many of the best answers are in the developing world. The west will need its youthful emerging hinterland more than ever.

But we can surely go much further in imagining where this might take us. If the early 2000s were about the integration of China and the west, the 2020s are poised to see something much broader: 4 billion people in 100-plus countries that are doubling down on trade with each other as well as with both sides of the geopolitical divide.

Evidence of this new world order is already becoming economic reality, with trade between emerging market economies at all-time highs, and a doubling in China’s trade surplus over the last three years. And to the extent that this trade is increasingly happening in currencies other than the dollar, this will further liberate emerging markets from the dependence they have always had on US policy.

The profits from this new wave of globalisation are unlikely to be recycled into US treasuries or UK property, they will far more likely be reinvested into emerging markets themselves. This could be a far more powerful and self-sustaining trend than anything that has unfolded before.

The prospect of the world’s centre of economic gravity tilting back towards emerging markets in the decades ahead is made more tantalising by the fact that the calibre of companies available to equity investors has never been higher.

As those big numbers finally kick in, and shiny new data networks are helping to unlock entrepreneurialism in the emerging world in much the same way as they have already done in developed markets and China, a growing number of interesting and differentiated businesses have been appearing from India, Brazil, Indonesia, and other parts of the emerging world not historically known for their corporate dynamism.

This is a new generation of companies capable of carving out their own destiny, rather than submitting to macro cycles.

Take one of the largest holdings in our GEM portfolios, Mercadolibre: this company has compounded its revenue at over 40% per annum in USD terms over the last decade against a backdrop of severe economic weakness in many of the markets in which it operates, with local currencies losing anywhere from half to nearly 100% of their value against the dollar. In currency-neutral terms, growth has compounded at nearly 80% per annum.

But with the ecommerce and fintech opportunity still in its early stages and the company’s competitive position increasingly entrenched, what could happen to those growth rates in the decade ahead if those macro headwinds now become a tailwind?

Conclusion

The title of this piece is a nod to the Latin adage about the passing of time, the full version of which is usually translated as ‘times change, and we change with them’.

We’re used to talking about stability at Baillie Gifford – stability of our ownership structure, stability of our process and philosophy, stability of our investment personnel – but the whole point of that stability is to give us the best chance of prospering in a dynamic asset class that has changed dramatically since 1994.

We don’t know what the next 30 years will bring, and we’ve seen enough shocks and crises to understand that the future is uncertain. But we’ve also seen enough to know that the underlying trend is one of inexorable progress.

And it now seems to us that the stars are aligning for emerging market equities – given the starting point in terms of expectations and valuations, the resilience of macro drivers and quality of the opportunity set – in a manner that may be more powerful than anything we have seen since the early 2000s. 

I’ll finish by expanding on a point I made at the start: while we’re immensely proud of our reputation and track record, it’s the relationships we’ve established with clients that pleases us most.

Over half of our clients have been with us for more than a decade, for many it’s closer to two decades. We’ve been grateful for their challenge during the good times, and for their support during the occasional but inevitable bad times. We couldn’t invest in the way that we do without it.

[1] Baillie Gifford launched the Emerging Markets Growth Fund in 1997, and the Emerging Markets Leading Companies Fund in 2005.

[2] Nominal Gross Domestic Product is calculated using current prices, without adjusting for inflation.

[3] The work of Elroy Dimson, Paul Marsh and Mike Staunton is often cited to support the argument that there is no link between equity returns and GDP. However, as they discuss in their 2014 yearbook, this is a misrepresentation of their research.

[4] Secular growth companies are typically less affected by changing macroeconomic conditions.

[5] See for example: ‘ESG and financial performance: aggregated evidence from more than 2000 empirical studies’

[6] See for example: ‘Emerging Markets: the possibilist’

Past performance

Annual past performance to 31 March each year (net%)

Source: FE, Revolution, MSCI. Total return net of charges, in sterling. Share class B-Acc.
Share class returns calculated using 10am prices, while the Index is calculated close-to-close.
*MSCI Emerging Markets Index.
**MSCI Emerging Markets Index (in sterling) plus at least 2% per annum over rolling five-year periods.
***IA Global Emerging Markets Sector.

The manager believes this is an appropriate target given the investment policy of both funds and the approach taken by the manager when investing. In addition, the manager believes an appropriate performance comparison for both funds is the Investment Association Global Emerging Markets Sector.

Past performance is not a guide to future returns.

Risk factors

Investments with exposure to overseas securities can be affected by changing stock market conditions and currency exchange rates. Investing in emerging markets, where difficulties in dealing, settlement, and custody could arise, may negatively impact the value of your investment.

The views expressed in this article should not be considered as advice or a recommendation to buy, sell or hold a particular investment. The article contains information and opinion on investments that does not constitute independent investment research, and is therefore not subject to the protections afforded to independent research.

Some of the views expressed are not necessarily those of Baillie Gifford. Investment markets and conditions can change rapidly, therefore the views expressed should not be taken as statements of fact nor should reliance be placed on them when making investment decisions.

Baillie Gifford & Co Limited is wholly owned by Baillie Gifford & Co. Both companies are authorised and regulated by the Financial Conduct Authority and are based at: Calton Square, 1 Greenside Row, Edinburgh EH1 3AN.

Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.

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