India, Indonesia, and Brazil Are About to Outshine Other Emerging Markets. Here’s How Investors Can Profit. – Barron’s

That is still the reality for a handful of troubled emerging markets, including Turkey, Colombia, and South Africa. But as Barron’s reported earlier this year, more emerging markets this time around are in better shape.

Strong demand for oil and metals like copper and nickel is helping commodity producers, including Indonesia. Emerging market central bankers, such as those in Brazil, have been earlier and more proactive in fighting inflation than the Fed. Structural trends—including tensions between the U.S. and China and the war in Ukraine—benefit countries such as India and Indonesia.

The MSCI Emerging Markets index, at 10.5 times next year’s earnings, is cheaper than the 14 times it has averaged since 2010. With the pandemic, emerging markets have traded at their cheapest valuation versus developed markets since the global financial crisis. Part of the discount stems from the long list of troubles plaguing China—which accounts for almost a third of the MSCI index—as it grapples with a property slump and zero-Covid approach that has locked down millions of people in major cities.

Optimists hope that China will continue to introduce more stimulus and ease up on its Covid lockdowns after October’s 20th Party Congress, when top leadership is selected—moves needed for Chinese stocks to recover meaningfully.

But some emerging markets are already attractive. Brazil, India, and Indonesia are primed to outperform, as their economic situations offer an attractive counter to the challenges facing the U.S. and China.

While the U.S. and European markets are just now feeling the sting from higher prices, Brazil ended last year as one of the worst-performing markets as the country battled double-digit inflation. Corporate earnings took a hit.

Brazil’s central bank raised interest rates over the past 18 months from 2% in early 2021 to 13.75%. That has put it far ahead of its U.S. and European counterparts and closer to the end of its rate hike cycle, with possible cuts coming later this year or next.

That would set up valuations to recover, while U.S. and European valuations are weighed down by rising rates, says Todd McClone, co-manager of the William Blair Emerging Markets Growth fund (ticker: WBEIX), which has been buying more stocks recently in Brazil.

One way to tap into Brazil’s improving outlook is through Brazil’s stock exchange operator, Brasil Bolsa Balcão (B3SA3.Brazil). “As rates go down, equities should bounce, and there will be more secondary and initial public offerings,” McClone says. “Brazil is unique in that it has a private-equity culture, so we could get more IPOs.”

As Brazil’s outlook improves, GQG Partners Chairman and Chief Investment Officer Rajiv Jain favors energy, materials, and financial companies, including oil giant Petrobras (PBR) and Banco Bradesco (BBD). The bank trades at 6.6 times 2023 earnings and generates a 16% return on equity. Jain thinks it can pay more than a 7% dividend yield.

“There’s a fear of nonperforming loans because of higher rates, but [the sector] is not coming from a period of crazy lending in this cycle like it did in 2013 to 2014,” Jain says. Such loans “will rise but not spike,” he predicts.

Brazil’s presidential election in October could inject volatility. The leftist candidate, former president Luiz Inácio Lula da Silva, is expected to edge out President Jair Bolsonaro. At current prices, the market is already bracing for a Lula victory. An upset by Bolsonaro would offer markets a boost, McClone says.

Longer term, the country stands to benefit from the energy transition. Brazil is known as a major oil producer. More surprising is that roughly 85% of its installed power-generation capacity is renewable, including hydro and wind—the highest of the Group of 20 nations, according to TS Lombard.

Indonesia is also well positioned for strong commodity demand, especially as countries scramble for alternatives to Russia’s nickel and oil. Demand for its metals and palm oil has contributed to a record current-account surplus, helping to keep the rupiah relatively strong. Its resources position it well for the long term, with many of them needed for green-energy products.

The short-run bull case for Indonesia is that the economy is reopening as Covid restrictions are eased. Retailers are in the sweet spot for a recovery, says Laura Geritz, co-manager of the Rondure New World fund (RNWOX), which is overweight Indonesia with companies like Ace Hardware Indonesia (ACES.Indonesia).

While Indonesia is among the best-performing markets so far this year, McClone, who has a heftier allocation to the country than peers, still sees potential, noting that Indonesian companies are expected to generate 30% earnings growth in the coming year. McClone’s fund owns companies such as Bank Rakyat Indonesia (BKRKY), a microfinance lender with a 30% return on equity, and United Tractors (UNTR.Indonesia), which sells equipment for coal mining, which is seeing increased demand in the wake of disruptions created by the war in Ukraine.

Indonesia and India are also well positioned to take market share in the global supply chain from China as U.S.-China tensions increase and companies look to diversify production, especially in areas like technology, medical equipment, and high-end manufacturing.

If there’s an emerging market that fund managers see as taking China’s role in the asset class, it is India, which Capital Economics says is on track to becoming the world’s third-largest economy by 2030. Foreign investors have been net buyers of stocks in India in recent months.

While China is struggling to get out of its economic rut, India is emerging from a decadelong malaise, following years of tackling a debt crisis and short-term pain from major structural reforms—among them tax reform and demonetization, which invalidated 85% of the currency in circulation overnight in 2016 in a bid to crack down on tax evasion and corruption.

India’s corporate and bank balance sheets are in their healthiest condition in almost a decade. The changes that took a while to digest are now collectively “repowering India,” says Justin Leverenz, manager of the Invesco Developing Markets fund, which has a fifth of its portfolio in India.

He points to a wave of digitization and formalization of swaths of India’s informal economy. India is also at the cusp of a housing and credit growth recovery—a marked contrast to China, which is reeling from a property market bust.

William Blair’s McClone is finding opportunities in HDFC Bank ( HDB
), which he describes as the JPMorgan Chase of India, as well as tile company Kajaria Ceramics (KJC.India) and property developers including Oberoi Realty (OBER.India), which is well positioned for a housing recovery.

India is one of the pricier parts of emerging markets. It is also an energy importer, needing roughly 1.1 billion barrels of oil a year. While energy prices have eased off their highs, McClone says a $10 increase in oil prices would hurt its fiscal situation and hamper its expected economic growth, which the International Monetary Fund forecast at 7.4% economic growth this year.

While roughly 5% of its energy needs came from Russia before the war in Ukraine, that has climbed to 20%—and that oil is priced at roughly a 20% discount, McClone says. Policy makers are also helping to buffer its currency by tapping $50 billion of its reserves. Further weakness is a risk, but India still has roughly $560 billion in its reserves.

India, Indonesia, and Brazil combined account for less than a quarter of the broader emerging markets index. Some active funds have higher allocations, including Jain’s GQG Partners Emerging Markets Equity fund (GQGPX), which has a quarter of assets in India, 18% in Brazil, and almost 2% in Indonesia. McClone’s William Blair Emerging Markets Growth fund has 21% in India, 6% in Indonesia, and 5.6% in Brazil.

Other funds with strong track records and bigger exposure to at least two of the three markets include Rondure New World, which has 17% allocated in India, 8% in Indonesia, and 3% in Brazil, and Touchstone Sands Capital Emerging Markets Growth (TSMGX), which has 11% allocated in Brazil, almost 31% in India, and 3% in Indonesia. Fidelity Emerging Markets Discovery (FEDAX) has about 9% allocated in Brazil, 19% in India, and 4.5% in Indonesia, according to Morningstar Direct.

Given the sharp moves in currencies, with the yen and euro falling to multidecade lows versus the dollar, Jain says he sees more macroeconomic risk in developed markets like Japan and Europe that are grappling with high levels of leverage, less fiscal discipline, and anemic growth prospects than emerging markets like India, Indonesia, and Brazil.

While emerging markets are far from immune to the jitters hitting the U.S. and other markets, some of these countries are going against the trends playing out in the U.S. and Europe. That is a good reason to take a closer look.

Write to Reshma Kapadia at reshma.kapadia@barrons.com