Back Where We Started: The Outlook for Emerging Market Small Cap Stocks

We began the year quite optimistically, expecting greater than 40% growth in EPS¹  – by far the highest increase forecast across the various global equity markets. This was welcome news, as earnings growth had been soft for a few years – pressures from global trade traumas and a stronger US dollar (since 2016) had been unwelcome headwinds for far too long. But investors were beginning to notice this newfound growth potential, as firms trumpeted their strong 2020 fundamental stories.

Unfortunately, along comes the COVID-19 pandemic, and it wipes out another year of profits for the asset class, along with many lives and livelihoods. I won’t begin to dissect the full impact of the pandemic in this note, but my instinct tells me a few things: The pandemic isn’t over, and the longer-term impacts are too difficult to assess. On the positive side, policy makers have acted strongly, and there is a public health response roadmap to take.

The market has shaken off the COVID shock – this has been the shortest bear market in history. From the end of 2019, 41% was wiped off EM small cap (EMSC) equity values (to the trough in late March), but they have since bounced back a whopping 64%.²

So, why are investors optimistic? I’d offer several reasons. The global policy response, especially from central banks, has been very positive for liquidity conditions across all markets. The extra liquidity has taken out, or perhaps more accurately, socialized, a good chunk of the risk in the global financial system. Central banks feared a collapse given the unknowns of COVID and have chosen the “big-bazooka” response, with over $6 trillion injected into the system from the big-three central banks (see Figure 1). The potential inflationary impact is a far more palatable policy choice versus a pandemic-induced collapse – which had to be avoided. If we add in the fiscal response, clearly some of this stimulus has found its way into global equities.

Secondly, the 2020 EPS figure, while bad, hasn’t been the disaster everyone had been expecting – profits are under pressure, but there is no GFC-style collapse. China, Taiwan, South Korea (all EM index heavyweights) have responded well to the COVID crisis and are recovering. They have shown the West that there is a public health roadmap to be taken that allows some degree of normalcy to return. These three countries make up more than 53% of the MSCI Emerging Markets Index and approximately 56% of projected 2020 profits.³  This support buffer has made the difference between a difficult outcome and a disaster. One of the keys to watch will be the sustainability of their success as we enter the fall/winter seasons.

I agree with most investors that COVID will be transitory, and my position has not changed.⁴  We’ve likely seen the depth of the impact (March 2020), but we still aren’t sure about the duration. This is the one area where investors need to pay careful attention. The ”end” would come about either through a successful vaccine or treatment regime, which would likely provide fuel strong 2021 growth. To be blunt, we could see the ”mother of all” V-shaped recoveries if pent-up demand and economic stimulus both get traction at the same time. Personally, I think the current rosy 2021 EPS growth estimates (e.g., more than +35%)⁵  reflect an inertia among analysts, who are waiting for more company guidance in the September/October timeframe. However, a successful health regime could begin a powerful synchronous global economic recovery, the likes of which we last saw in the post-GFC timeframe. Earnings in this environment could mirror what was delivered in 2010, i.e., increasing 23% year over year.⁶

A final reason for optimism here would be the impact of the US dollar. The USD rallied sharply due to fear, the flight to quality, and, in general, tighter liquidity conditions. So, it makes sense that the recent weakness is just an unwind, as market conditions improve and fear subsides. But so far, the dollar weakness is about Euro strength, and EM currencies aren’t that well bid given their very low real rates and experiments with QE. A reversal, or normalization, of EM policy would be very supportive of EM FX in an environment of global synchronous recovery.

What about de-globalization? There will be some regulatory response, perhaps in areas deemed critical (pharma, PPE, some tech components), but we have ”crossed the Rubicon” in terms of globalization. The dynamics of major supply-chain onshoring will be costly, and there will be many other bills to pay for the COVID pandemic response. This is low on my list of worries.

As we head into the fourth quarter of 2020, State Street’s EM Small Cap strategy continues to carry an overweight to China, South Korea, and Taiwan – large Asian markets that offer the most breadth, liquidity, and sector diversification in the EMSC universe. These are also the countries that have met the challenges of the pandemic, both from a health and economic point of view. They will be best positioned for the medium term. This overweight is funded by underweights to Latin America and EMEA. From a sector perspective, the portfolio has long exposure to Health Care and Information Technology sectors, and underweights to Financials and Industrials.

We continue to keep an eye on cash generation and leverage in our portfolios. Some companies in the Latin American transport sector have high debt and no customers. They have rallied alongside all risky assets, but these are names that remain on the precipice.

A final reminder for investors is that idiosyncratic risk and trading costs are likely to remain high until we see the backside of COVID-19. The secondary and tertiary impacts on the macro and micro fundamentals are going to create both real and paper tigers. Even though the market has come back, it is hard to call this environment “normal.” It is important to partner with a strong manager to help guide you through this period.

Risks to Recovery

In closing, having already seen one “swan” this year, I would be remiss in not listing three risks that could potentially alter the scenarios I have outlined:

• COVID remains a headwind, pushing out recovery to 2022 or later Vaccine trials disappoint
• The fiscal/monetary policy response loses traction. Gold goes to $3500, US rates go negative, deflation sets in
  
• COVID health challenges are addressed in developed markets, but they linger in poorer ones