In recent weeks, EM growth stocks have outperformed EM value stocks, prompting many investors to wonder if the reflation-driven rally is coming to an end. What are your views on EM growth versus EM value for H2 2021 and into 2022? What might signal an end to EM value outperformance?
Laura. An environment of rapid economic recovery and reflation is supportive of sizeable earnings recovery for stocks in traditional cyclical value sectors such as Energy, Materials, Industrials, and Financials. Despite continued strong earnings from many names so far in 2021, the risk of higher US and global yields will continue to weigh on higher-valuation growth names in the IT, Communication Services, and Consumer Discretionary sectors. Failure of US yields to continue to rise in Q2 has taken some of the steam out of the rally in value stocks and given growth stocks room to resume leadership. It is too soon, however, to suggest that the reflation trade is over in the near term.
In the medium to longer term, we see three key headwinds for deep-cyclical value stocks:
In sum, once the cycle peaks and earnings momentum turns, growth stocks will resume leadership as they continue to benefit from the secular and structural advantages that allow them to deliver strong earnings growth over the long term.
The value style of investing has had a difficult past 10 years. With value surging steadily ever since hitting pandemic-induced lows, can it continue to have its day?
Chris. Like most quantitative investors, AQE believes in the importance of valuation as an anchor of an investment process. However, we are not looking for value for its own sake and want to balance it with other growth, quality, and ESG characteristics. While value may be a key part of our process, it isn’t always the dominant one. If we can find companies with good value and growth characteristics, we will quickly zero in on them. For example, right now a few of our favored areas are IT Hardware, Semiconductor, Healthcare Equipment, and Materials firms. By way of contrast, many of the new economy firms have fantastic prospects, but it would take careful examination to find the firms that ultimately deserve their current valuations.
The traditional “markers” for value (e.g., reflation, as noted above) did appear in the first part of 2021, but they have recently paused. I do believe there is scope for continued value recovery, especially as US infrastructure legislation continues to make progress. EM value remains an uncrowded trade – priced at just over 10x earnings – and with 46% EPS growth expected in 2021 this sector should warrant increased interest. Monitor the EPS revision cycle for 2022 to see if EM value continues to have legs; so far, ROE estimates appear to be holding up for value names.
Lastly, regulatory concerns may well keep idiosyncratic risks higher for “growthier” companies. Do growth names still deserve a 50% premium in this environment? Stock pickers will need to ensure the sustainability of business models. See Figure 1.
Figure 1: MSCI EM Growth/Value and US 10-Year Real Yield
January 2, 2003 to June 25, 2021
Given China’s rising importance to the global economy and its large weight in EM indexes, what are your thoughts on this key market? Where are the opportunities, and what’s next for China?
Laura. China will continue to be a key driver of global economic growth, along with the US. The relative slowing in China’s growth momentum relative to the US since late 2020 will impact individual EM countries differently, but the strong recovery in both China and the US is positive for EM assets broadly.
The most attractive areas of growth in China are still (1) the areas that benefit from continued rising wealth and changing consumption patterns of Chinese consumers and (2) the brands that benefit from a “Made in China” identity. China’s economic recovery since the pandemic has been driven largely by the manufacturing and construction sectors. However, global demand for China exports has been boosted by global consumption growth, and services are also beginning to recover. Household income in China should continue to grow steadily from this point, supporting the recovery in consumption and strengthening overall internal economic growth momentum. This trend should continue for many years. Many of the stocks that capture this opportunity fall into new economy growth sectors.
Chris. There are two conflicting forces in China. The secular, domestic growth story in China will be decades long. Issues with leverage, regulation, and valuation may cause some challenges here and there, so diversification will be important. Our view is that stock-specific risks rise with valuation levels, and therefore we believe that all investors should balance their growth positions, even if they are index-oriented. We are modestly overweight China, and we favor the IT Hardware, Healthcare, and Industrial names. The last point I’d like investors to remember is that the profitability of Chinese firms remains superior to that of firms in almost all other emerging markets. Even with the pandemic and anemic global growth, Chinese companies are operating at a 11.7% ROE, which is still higher than much of the rest of EM as well as developed markets excluding the US (see Figure 2). They are making money for their shareholders.
Figure 2: Return on Equity (ROE)
%, as of May 28, 2021
As mentioned above, emerging markets continue to move toward a “new economy” profile. However, there is still a lot of commodity exposure coming from the “old economy” sectors. Is the new excitement for commodities the start of a new super-cycle?
Laura. Commodities are an enduring subject in the old economy/new economy debate, especially in emerging markets. Traditionally, commodity-related companies in EM are in the Energy and Materials sectors. Many of these companies have heavy state involvement or are State-Owned Enterprises.
However, the pandemic created supply disruptions and bottlenecks from agriculture to mines, while OPEC+ constrained production levels forced energy prices higher. Depressed supply in the face of increased demand pressures has pushed prices for many commodities to their highest levels in over a decade. Those demand pressures came from economic recovery, increased mobility, restocking, climate initiatives, the potential for large US infrastructure stimulus, as well as financial demand for commodities as inflation hedges.
We still don’t see a lasting commodity super-cycle now. The last commodity super-cycle (2001-2010, 2014) was driven by industrialization and urbanization in China after the county joined the WTO in December 2001. China’s broad commodity demand and strong economic growth during that super-cycle period drove overall EM growth higher relative to DM growth. Currently this is not the case, as the EM-DM real GDP growth differential is moving lower (see Figure 3). Also China’s credit impulse peaked in Q4 2020, suggesting that momentum for cyclical recovery in China has peaked. In our view, the current recovery in commodity prices and the supportive backdrop for commodity prices make this a commodity cycle, not a super-cycle (see Figure 4).
Figure 3: EM-DM Real GDP Growth Differential
Figure 4: China Credit Impulse
December 31, 2008 to June 25, 2021
Chris. I agree with Laura 100%. Cycle yes, super-cycle no. China is unlikely to repeat its ultra-high fixed asset investment (i.e., commodity demand) because its growth model has shifted. There is no other country (or set of countries) likely to pick up that pace of infrastructure investment. Some have argued that the shift to green tech will spark a boom in commodities, but this is not yet clear to me. Nonetheless, we will be seeing a synchronous growth recovery, and this will be supportive for 12-18 months. Prices and company forecasts are telling us this. It is also interesting to note that most commodity firm analysts believe that 2022 profitability will mean-revert from this year’s bounce.
Laura. One last point. Some commodities, such as copper, may appear to be in something close to a super-cycle, but this is not the case for all commodities. Demand for “green” commodities such as copper, cobalt, and lithium should also remain well supported for some time.
Can you talk about potential risks on the horizon for EM, e.g., deficits, debt, or policy? Which countries are best equipped to weather these risks?
Laura. We see two key external risks for EM assets generally. The first is weaker-than-expected Chinese growth, and the second is higher US real rates and/or a strong US dollar. There are two specific things to monitor with respect to China – the government’s reaction to the recent uptick in COVID cases and a renewed focus on deleveraging. As for the US, the key focus remains the timing and magnitude of a change in Fed policy in the face of potentially more persistent rises in inflation.
Opportunities and risks across EM countries vary widely. In the context of the potential external headwinds from China and the US, we see countries that entered the crisis with better debt and deficit levels – as well as more policy space and policy credibility – faring better from a macro vulnerability perspective (see Figure 5). Fiscal risks are heightened by the social-economic impact of the crisis as well as the busy political/election cycles that are already under way in EM. Countries such as Korea, Russia, Taiwan, and Mexico have higher debt and deficits as a result of the pandemic, but these are still at comparatively manageable levels. Countries such as Brazil, India, and South Africa face a much more difficult road ahead from a fiscal and debt position. Chile, Korea, the Philippines, Hungary, Colombia, and Brazil all have presidential elections set to take place between now and the end of 2022.
Figure 5: General Government Fiscal Deficit, 2020 versus 2019
% of GDP
Chris. From the micro perspective, it is good to see the EM ROE heading in the right direction, but we need to admit that much of this is driven by leverage (see Figure 6). Asset efficiency and corporate margins (the drivers of return on assets) are improving, but slowly. As Laura mentions, a world that reprices risk aggressively could mean the end of the credit cycle in emerging markets. I agree with her that higher rates may be fine as long as they are accompanied by improving economic growth. But I also think we need to admit that the pure style trades – anything growth in (2019/2020) and anything cyclical value (in 2021) – are done and that selectively and quality will be the keys to generating returns. The easy money has already been made.
Figure 6: EM Return on Equity (ROE) versus Return on Assets (ROA)
%, as of June 25, 2021
Chris Laine is a Senior Portfolio Manager for emerging market strategies on the Active Quantitative Equity team. He has been at State Street Global Advisors since 2007 and has worked in emerging market investing for over 25 years.
Laura Ostrander is Co-Portfolio Manager on the Emerging Markets Select strategies and Macro Strategist on the Fundamental Growth and Core Equity team. She is responsible for EM macro strategy, including country and currency research and analysis, economic and political monitoring and risk assessment, country/currency allocation, and valuation analysis. She has worked in global and emerging market investing for over 25 years.
Chris and Laura would like to thank Chris Carpentier, Investment Strategist on the Investment Strategy and Research team, for his insights on the EM issues that are most important to State Street clients.
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Exp. Date: 07/31/2022