We believe emerging markets (EMs) offer a multitude of benefits to equity investors, including: 

• High growth potential. EMs typically follow rapid economic growth trajectories, which can be reflected in the performance of companies operating within these markets. 
• Undervalued quality assets. EMs are home to many high-quality companies not yet recognized by the broader investment community. As these companies grow, they gain awareness and appreciate. 
• Diversification. Investing in EMs can help diversify portfolios concentrated in more developed markets, enhancing their risk-return profile. 
• Favourable demographics. Most EMs have young and growing populations that can drive economic growth and provide opportunities for companies catering to these markets. 

Small-cap (SC) companies can often have significantly more room for growth than their larger peers, as they launch new products and expand into new markets, providing substantial upside potential. Also, because they are typically less known outside of their domestic market and inadequately covered by sell-side analysts, they can present “hidden gem” opportunities that the market maybe be overlooking. The EM SC investable universe comprises over 11,000 companies offering a wide variety of investment ideas across 24 countries and 11 sectors. 

For a company to be included on our shortlist, it must be run by an outstanding management team and have a sustainable competitive advantage and defined growth strategy within what we believe is an attractive market. Although we are bottom-up investors, we are also macro aware and acknowledge secular investment themes in the EM middle-class consumer space. Notably, EM countries have nearly four times the middle-income households as their developed market counterparts.  

Indonesia, which we last wrote about in August 2021, is the largest economy in Southeast Asia, the world’s fourth most populous country and home to more than 50 million consumers in the middle-income bracket. Amid gloomy economic projections for many countries globally, Indonesia is expected to experience only a mild slowdown and actually grow 4.8% in 2023. Its economy is supported by strong exports, investment (with foreign direct investment having consistently posted new records every quarter last year) and household spending (being the most significant GDP contributor). Even with the possibility of a global recession and a tight global financial environment threatening Indonesia’s momentum, our view is that companies with sustainable business models, pricing power and appealing product offerings can nevertheless extract meaningful benefits. We believe that one of our Emerging Markets Small Cap portfolio’s core holdings offers the best exposure to Indonesia’s middle-income consumers.

Business overview

Mitra Adiperkasa (MAPI IJ) is Indonesia’s leading multi-format lifestyle retailer catering primarily to middle- and high-income earners. Since its establishment in 1995, the company has managed to build a diversified portfolio of franchise agreements with more than 150 world-class brands (e.g., Zara, Marks & Spencer, Footlocker, Converse, Starbucks, Subway, Krispy Kreme, Tissot, Pandora, Sephora, Samsonite). Mitra Adiperkasa has cultivated long-term relationships with its principals and secures exclusive rights from virtually all brands it partners with. Supported by a veritable army of 23,000 employees, the company runs an omnichannel network of nearly 3,000 physical and 20 online stores. In 2016, Mitra Adiperkasa started its overseas expansion venturing into Vietnam, followed by the Philippines in 2020, and Malaysia and Singapore in 2022.

Competitive advantages

• Diversified portfolio of exclusive brands and long-term relationships with principals.  
• Unmatched scale and store network. 
• Strong reputation and track record of execution. 

• Focus on target customers with resilient purchasing power. 
• Solid balance sheet with net cash position. 

Growth strategy

• Same-store sales growth and store network expansion, with a focus on higher-profit specialty stores. 
• Addition of new brands and optimization of existing ones. 
• Expansion in Vietnam, the Philippines and Malaysia. 

A combination of target demographics with more resilient purchasing power, a diverse portfolio of exclusive brands and a robust omnichannel strategy in our view make Mitra Adiperkasa one of the best-positioned consumer companies in the EM SC universe.

With COVID-19 restrictions behind us, our team has been hitting the road, meeting over 300 companies in the past two months at conferences and onsite, from India to Chile, from Florida to Whistler. One of the conferences we attended was the 32^nd BMO Global Mining & Critical Minerals Conference that took place in Florida from February 26 to March 1.

The largest conference of its kind, it brings together over 350 companies including all the majors: Rio Tinto, BHP, Vale and Freeport-McMoRan. We met over 30 companies and attended various panels.

New this year was inviting critical minerals companies that explore and produce lithium, cobalt, graphite, and other metals. These will be key on the journey to decarbonization, either via battery-electric vehicles or renewable power.

It is always interesting to attend a mining conference. The optimistic nature of management teams, the promotional aspect of companies trying to raise billions to find metal in a pile of rock in a remote area and then building the mines, roads and infrastructure to bring it to production. There are many interesting characters to say the least.

What were some observations and how does it relate to our commentary this week about the battle against inflation? One main takeaway is that the two megatrends of urbanization and the need to reduce carbon emissions to limit the temperature rise are very much intact. China at 64% is probably two-thirds of the way in terms of people moving to cities. As a comparison, the U.S. is at 83% whereas countries like India are only at 36%.

Share of urban population worldwide in 2022, by Continent

Urbanization comes with the need to build new infrastructure as well as replace aging infrastructure, some dating as far back as the 19^th Century.

An interesting fact is that since the beginning of the Copper Age around 4500 BC, almost 7,000 years ago, 700 million tons of copper has been mined until today. In the next 25 years alone, the world will need another 700 million tons.

Where will we find it? How much will it cost to bring it into production? We can assume it will be a lot more, in other word, inflationary.

Copper price 1989 to today

This is a long introduction to this week’s commentary. Are the central banks winning the war on inflation?

Earlier this year, market participants thought we had made good progress as we started to see inflation numbers come down from their peaks. We started assuming interest rates had peaked and would even start to decline in the second half of 2023.

Since then, economic data out of the US, Canada, Europe and China has shown:

• a resilient economy,
• a confident consumer,
• strong job creation. And surprise!
• an increase in inflation from December to January.

US Personal Consumption Expenditure Core Price Index YoY

Obviously, bond and stock markets have retraced much of their positive returns.

Where is inflation headed now?

Let’s focus on the US.

Components and weight in CPI calculation (source Bureau of Labor Statistics)

Food and beverages	14.40%
Housing	44.4% of which owner equivalent rent of residence is 25.4%
Apparel	2.50%
Transportation	16.7% of which 8.1% is new and used vehicle
Medical Care	8.10%
Recreation	5.40%
Education and Communication	5.80%
Other good and service	2.80%

In aggregate, commodities including food and beverage is approximately 41% and services is 59% (includes rent).

Graph of US CPI Owner Equivalent Rent YOY

So, as can be seen from the weight of the various components and the chart above, rent will go a long way in terms of determining the direction of inflation. Although we have recently heard of rent peaking, we are still looking at high single-digit increases on a year-over-year basis. Since this data normally lags about six months, we do not expect a large decrease in this measure to bring down inflation. Furthermore, looking at the graph above, it has mostly been above 3%, except the period following the global financial crisis of 2008.

Last December, we were of the view that inflation would still be above 5% at the end of 2023, a view that was not widely shared. Now in March, the data seems to validate our view.

The Fed needs to continue raising rates. How high will they go?

The market now expects a terminal rate at around 5.5% and many funds are buying options where rates may reach 6%.

We still believe the only way to break inflation expectations — which is what the Fed is focused on — is to see slack in the labour market.

That probably means an unemployment rate above 6% and we are far from that level.

With Delta Airlines announcing this week there will be an increase of 34% for its pilots for the period 2023-2026, we are far from seeing wage increases at 2%.

We also need to see home prices decline by 20% or more. Prices are still going up year-on-year and should register their first modest decline by April of this year.

As we wrote last week, the recent rally has been of poor quality. Like in the summer of 2020, unprofitable companies with weak balance sheets have been the best performers.

Our portfolio is well positioned for a more difficult environment in 2023, i.e., much lower economic activity and even a recession combined with higher interest rates.

Toward the end of the first quarter of 2023, we expect a rotation to higher quality companies with little or no debt and the ability to gain market share. We are already seeing green shoots with small cap and international markets outperforming this year.