Outlook Bullish but Recovery Might Be Uneven
Assets were fleeing emerging markets in the early part of 2020 as COVID-19 took hold, oil prices tumbled and economic growth stalled. But flows recovered quickly over the summer as investors reassessed their approach to the asset class.
“This was about the most bullish we’ve seen either the sell side or buy side on emerging markets in the last several years, as we headed into 2021,” said Gaurav Mallik, chief portfolio strategist at StateStreet Global Advisors. He credited the sentiment driving the EM recovery to a changing political landscape and supportive macro trends such as dollar weakness, a commodity price rally and reflation.
“The big question for investors is whether this is a rally just for 2021, which presents a tactical opportunity, or whether it’s a setup for a sustained structural rally in EM assets that requires rethinking strategic allocations,” Mallik said, pointing out that institutional allocations to EM have slipped from their highs back in 2010 and 2011. “From a valuation standpoint, we believe there is a long-term strategic benefit to being in EM, driven by growth in China, consumer trends, digitization and other structural drivers. The cautions would be around debt levels and the testing of resiliency in EM assets as monetary and fiscal support are withdrawn.”
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“Relative to their size and importance in global equity markets, strategic allocations appear to be underweight EM,” said Michael Orzano, senior director of global equity indices at S&P Dow Jones Indices. He illustrated with key data points: Emerging markets represent approximately 12% of global equity indexes, like the S&P Global Broad Market Index, or BMI, measured by float-adjusted market cap, which excludes strategic government holdings and takes into account foreign ownership limits. Taking a broad look at total global equity market capitalization, emerging markets represent more than 26%; and in terms of global GDP, EM represents almost 60% at purchasing power parity, according to Orzano.
“When you think about just how large and important emerging markets are, and you look at all the key data points, they highlight the home bias and domestic orientation that one sees in a typical institutional asset allocation,” Orzano said.
As investors consider both the tactical and strategic opportunities presented by EM, two key issues come into focus: a shifting fiscal and monetary backdrop, and a potentially uneven post-COVID-19 recovery across both geographies and industry sectors.
“Investors have been skeptical because emerging markets governments do not have the balance-sheet firepower to launch ‘helicopter money’ in the same way that developed market governments do,” said Ernest Yeung, portfolio manager for emerging market equities at T. Rowe Price, referring to the easy-money policies of the world’s largest central banks during the global financial crisis in 2008 and again during the pandemic. “We understand that kind of logic, but we don't fully agree with it, and there are a few disconnects within that view.”
Yeung pointed out that despite quantitative easing in some markets, broad fiscal deterioration across EM was less than expected, especially compared with developed markets. Most EM governments pursued orthodox fiscal policies, and where fiscal balances did deteriorate, it was driven mostly by declines in gross domestic product. So fiscal imbalances should improve as GDP recovers. Moreover, restrictive lockdowns were less common across EM, and where lockdowns were imposed in larger EM economies, they were lifted quickly, clearing the way for a quicker recovery.
“We have seen signs that GDP and industrial activity across much of EM is rebounding, and in some cases much faster than developed markets,” Yeung said.
Winners and Losers Come into Focus
But the pandemic did bring forward a material difference between winners and losers, according to Samy Muaddi, portfolio manager for emerging markets debt at T. Rowe Price.
“Those countries and companies generating cash flow are performing well, and are offered abundant capital. Those that are struggling are not,” Muaddi said. “You see this in the value-growth dispersion in equity markets, as well as in the spread premium for the high-quality part of the EM bond market versus frontier assets.”
“Emerging market equities had a very positive year in 2020, gaining about 15-1/2%, but COVID has had a few effects, one being that more diverse emerging economies have fared better,” said John Welling, director of global equity indices at S&P DJI.
Welling explained that unevenness in the EM recovery was driven by sector composition at the country level: More advanced consumer economies and those with exposure to technology-related growth companies persevered to a greater degree. EM sectors such as financials, energy and industrials underperformed compared with information technology, healthcare, consumer discretionary and communication services. In addition to a greater exposure to high-performing technology sectors, Asian EM economies, such as China and Taiwan, also benefited from gaining quick control over the virus and avoiding the lengthy shutdowns of other economies.
“By November, the recovery in EM equities as an asset class was complete, but that’s not the whole story,” Welling said. “Emerging regions recovered almost on a rolling basis, moving from east to west as China and Taiwan recovered by mid-year, followed by India, then a majority of small European EMs, leaving Latin America the only region underwater by year-end. There were very big differences in performance, particularly when you look at sector composition as a driver of recovery.”
“COVID has accelerated existing digitalization and modernization trends that were already reshaping EM economies and should create a boost to productivity for many years to come,” said Sara Moreno, portfolio manager for EM equities at JennisonAssociates. “Trends like e-commerce shifting consumption from offline to online, the move to electric vehicles, cloud computing, software as a service [or SaaS], diversification and tactical management of supply chains — all of these disruptions create opportunities that are really long-term and structural in nature.”
Moreno said she sees a strong macro backdrop for EM as an asset class — from potential currency tailwinds, to GDP growth, to a rapid economic turnaround in China — providing a recovery anchor in Asia. “But amidst this recovery, it’s disappointing to see investors potentially focusing more on the old economy than the new economy, as many investors are led astray by investing in index-hugging strategies, which still have a high representation of old-economy sectors like materials, energy and financials,” she said.
“Everything isn’t just going to revert back to the way it was before,” said Albert Kwok, portfolio manager for EM equities at Jennison. “COVID has brought with it a paradigm shift in how consumers and business behave, and as equity investors, we have to understand, what the consequences are and how these effects will be felt across EM economies.”
As an example, Kwok pointed to travel and said he believes that leisure travel is likely to rebound, but business travel may not, given that remote work has been so successfully implemented without a loss in productivity. Capital allocations may shift as supply chains become more diversified and localized. In education, while in-person learning may be restored, trends in web-based complements and services, like digital textbooks and chatbot tutorials, may prove to be quite sticky — and the trend may stick around indefinitely if people aren’t willing to keep paying top-dollar for in-person college education.
“The old playbook simply doesn't work anymore,” Kwok said. “EM equities used to be driven by commodity cycles, fixed-asset investment, exports and liquidity flows. But increasingly, EM economies have moved up the value chain, and we’re finding more innovation and disruptive technologies in these economies, which are driving structural changes and productivity gains that policy reforms failed to bring. So this paradigm shift brings a whole new opportunity set for active managers.”
“The central question we deal with in conversations with clients is, which force will be more powerful, cyclical recovery of economic growth post-pandemic, or the headwinds from fiscal retrenchment?” said Aaron Hurd, senior portfolio manager for currency at StateStreet Global Advisors. “On that question we’re fairly constructive, believing that cyclical recovery will overcome any headwinds. Our big caution to investors is that even as we’re positive on EM from the macro outlook, and on currencies and spreads, one cannot use the last two recoveries and recessions as a model for expected returns. It’s going to be a bit more muted, and one has to position accordingly.”
EM Bonds: It’s All About the Currency
Conditions are becoming broadly supportive for EM bonds, led by a currency rally in the latter half of 2020, but how much can that continue, and how central is it to the whole emerging markets story?
“We believe a weaker dollar is a prerequisite for the EM currency trade to return,” Muaddi at T. Rowe Price said. “Traditional drivers of EM currency appreciation, like productivity gains and a collapse in inflation differential, aren’t likely to be any better than they have been over the last couple of decades. So, one could say that any EM currency appreciation would be dollar-dictated rather than EM-earned.”
“Looking country-by-country, yields are arguably too low to fully compensate for the variety of political risks, balance sheet risks and other risks facing investors, and so currencies are really taking the brunt of that,” Hurd said. “In order to get compensated for that risk, you’re relying on a recovery in the value of the currency, which is much scarier than just clipping a double-digit coupon. And while the currency backdrop looks positive, as EM currencies are historically undervalued, it’s not as bullish as it was in Q3 2020 because some EM currencies have already fully recovered.”
Hurd cautioned that investors need to very carefully assess how much currency recovery is already priced in, particularly in local bonds, which he prefers to hard-currency bonds.
“We look to differentiate on the countries that are turning the corner economically, where yields are decent and currencies have not yet caught up with the recovery,” he said. “We’re finding pockets of opportunity in Latin America, in Mexico, Brazil and Colombia. India stands out for its turnaround in growth, easing of the pandemic, reasonably high yields and moderating inflation.”
He contrasted those opportunities with currencies that have already recovered and, in some cases, overshot their pre-pandemic valuations such as the Korean won, Chinese renminbi and Taiwan dollar. “We do not dispute the strong economic outlook in Asia, it’s just largely priced in to the currencies. And, that is of particular interest to equity investors as China, South Korea and Taiwan are by far the largest exposures in the MSCI EM index.” Hurd said.
But the EM dollar-based credit market, particularly in Asia, should be a key focus for U.S. dollar-based institutional investors, according to Muaddi.
“While returns may be lower than they’ve been historically, the margin above Treasuries is largely unchanged,” he said. “So the real-return advantage, net of the risk-free rate, is almost as attractive as it’s ever been. We’re looking at the corporate high-yield market, companies that have been left behind and present both carry and capital appreciation opportunities.”
Muaddi said he is interested in the frontier sovereign market, but attentive to the risk of default, seeing opportunity in regions showing reform momentum, like parts of sub-Saharan Africa.
As for EM debt levels, he said he believes what’s more important than absolute debt levels is the source of the funding — domestic or foreign.
“There is too much focus on the stock of debt rather than how it’s funded,” he said. “I'm happy that people have been sounding alarms about China for six years. It means I can buy cheaper bonds. India and China today, despite all the controversy, are funded domestically and two areas of my highest conviction, to which I would add Chile and Thailand.”
Rising Tide Won’t Lift All EM Equities Equally
“The pandemic drew out differences across markets and highlighted the fact that EM is not just one homogenous region,” said S&P DJI’s Orzano. “There are a lot of differences across countries and regions, and we’re seeing opportunities in the bifurcation of EM, which is opening up new investment themes.”
Orzano said that COVID-19 has played a part in accelerating that trend, and increasingly, investors are digging beneath the surface to understand that performance drivers in some of the larger countries, like China and Taiwan, might be significantly different from other large markets, like India, or smaller European emerging markets and certainly Latin America.
As a result, investors need to understand the differences among indexes, based on which countries are included and how broad they are in terms of capitalization.
S&P DJI and a number of other index providers exclude South Korea from their EM equity benchmarks, based primarily on its level of economic development and per-capita GDP,” Orzano said. “In addition, it’s home to some of the biggest names in global tech, which earn a majority of their revenues from developed markets. So including South Korea in an EM benchmark can partially crowd out high-growth names with greater economic exposure to EM.”
As EM has become larger and more liquid, investors are increasingly looking for broader exposure across capitalization, including small-cap names along with large- and mid-caps, and seeking to take advantage of accessible slices of the market. An example of this is the S&P New China Sectors Index, which covers companies from industries poised to benefit from China’s transition from a manufacturing-based to consumer- and service-oriented economy.
“Even in what appear to be similar market-cap weighted EM indices, there can be significant differences in exposures, which can lead to meaningful performance differences over time,” Orzano said.
“The economic fallout from the pandemic is going to create winners and losers, as any shock to any system always does,” said Jennison’s Moreno. “When you look at returns in emerging markets, positive returns have been concentrated in the top two earnings quintiles of the index. We believe COVID will only increase such concentration because very large companies can grow at a very high compounding growth rate for many, many years. The next one billion emerging market consumers are expected to join the middle-class in the next five to six years. That’s a vast opportunity set, with favorable sectoral and structural trends in healthcare, lifestyle and services consumption.”
Moreno and Kwok take an unconstrained, benchmark-agnostic approach to EM, arguing that benchmarks in general fail to represent the dynamism that EM companies offer. As a result, they scour the world for sticky structural trends and the strongest growth opportunities across a range of sectors, such as healthcare, biotech, pharmaceuticals, SaaS and cloud computing.
“COVID has accelerated existing growth trends, like telework, some of which are going to be very sticky,” Kwok said. “Take e-commerce. Not only are consumers using it more, there has been a continued buildup of infrastructure that enables future growth. That’s why we think there’s no turning back. But within that trend, opportunities are shifting. China has been at the forefront of e-commerce for many years, but the trend is maturing quickly, with penetration approaching 25%. Outside China, however, in Southeast Asia and Latin America, e-commerce penetration is in the low single digits. And the pan-regional nature of the opportunity means that investors aren’t necessarily reliant on one country or economy to provide strong overall growth.”
Another area that is underrepresented in EM benchmarks, and off the radar screens of many EM investors, is healthcare. Moreno said many EM healthcare companies are moving up the value chain with innovative drugs, especially in China. “The Chinese are getting richer, older and sicker, and government reforms made over the last several years offer long-term investors compelling growth opportunities,” she said.
Economic Growth the Key Question
But one can reasonably ask, when coming out of a pandemic with an economic recovery partially fueled by easy money, how durable is EM’s economic growth?
“We think it’s likely EM will see reasonable growth, but probably more modest compared to five or six years ago,” said George Bicher, asset class CIO for emerging market equities at StateStreet Global Advisors. “It’s not going to be a tide lifting all boats all the time, which puts the spotlight on careful stock picking. The durability of that tidal flow may erode going from 2021 into 2022, and one could expect some separation among stocks.”
Bicher said that even while questions of durability persist, long-term stories of quality growth still make a lot of sense. Such names may be expensive, but they are still trading at reasonable price-to-growth valuations, while their business lines are still taking market share and seeing margins improve, which is a rarity, he said. And EM is home to some of the largest most innovative companies in the tech space, which will benefit from sticky, pandemic-driven growth trends.
“The pandemic has pulled growth forward several years in businesses like e-commerce. Are all those consumers going to quit using those platforms after the pandemic eases? Not at all,” he said. “We expect consumer use to increase as those companies broaden their merchandise portfolio and/or improve logistics.”
Jennison’s Kwok cautioned, however, that even the strongest growth trends bear watching for potential disruption. He cited batteries for electric vehicles as an example. “With economies of scale getting larger, sales beating expectations and the world adopting this new technology faster, the timeline for solid-state battery development may accelerate significantly over what we expect today,” he said. “When that happens, enormous portions of the global supply chain will become obsolete.”
Value Rotation in a Growth World?
In addition to quality growth stories, Bicher has his eye on some narrow cyclical opportunities, anticipating potential normalization of valuations in the financial space and a selective recovery in materials, such as those involved in electrification or digitalization of industries.
“Banks look interesting because we do feel comfortable that EM economies are going to improve, and that can lead to an improvement in asset-quality perception and improving valuations,” Bicher said.
“In early November we saw a broadening of the of the EM rally, and with it we saw a further recovery in oil and weakness in the dollar, which in the short-term, at least, seems to have set off a rotation into more value-oriented segments of the market,” said S&P DJI’s Orzano. “In the fourth quarter, positive vaccine news and the appearance of a broad recovery increased investor expectations for a return to a high-growth trajectory, economically. Investor interest broadened quickly into reconsidering areas of the market that were previously shunned.”
T. Rowe Price’s Yeung, who runs a contrarian, value-tilted strategy, said he sees potential for value stocks to recover following the biggest collapse in more than two decades, as measured by the growth-value return differential.
But more importantly, he said he believes the post-pandemic environment in EM has delivered a world that isn’t divided so much into growth and value stocks, but instead into COVID-on and COVID-off stocks. The key, at least in the value space, is to hunt for names that were hurt by COVID-19 but retain an ability to bounce back no matter whether such companies are traditionally seen as growth or value.
“Over the last 12 months, there has been a huge polarization between these two groups, with COVID-on names roaring along and COVID-off stocks being shorted and sold off throughout the year,” Yeung said. “Many quality companies, even high-quality growth names, got thrown out with the bathwater, so to speak, at the height of the pandemic. Some are still very depressed as we head into a COVID-off economy, and we think this is a very interesting pocket of opportunity to explore.”
As examples, he cited EM airport stocks, cosmetics companies, where a portion of sales occurs in duty-free shops, and previously richly valued hospital and healthcare names. Yeung said he expects that if current trends in vaccination and economic recovery persist, rapid normalization over the next 12 to 18 months should provide a sizeable boost to many discounted names.
He also cautioned that not all high-growth, COVID-on stocks will continue on a tear in a COVID-off world. “We have a bucket we call dogs, bikes and boats,” he said. “These are companies that derived huge benefits in demand because we were all locked at home. It’s important to sort out which companies benefited from bursts of consumption that are one-offs and may not repeat in 2021 and 2022.”