As developed market indices sit at or close to all-time highs, the baton of growth may be passed to Emerging Markets, given their strong economic fundamentals and undemanding valuation.
Regulatory risk in China remains but it may already be reflected in prices.
Emerging Markets are diversified within and may be played through regional or factor exposures.
Emerging markets have been unloved by investors so far this year as they were challenged by scarcity of vaccines, unexpectedly stronger USD and regulatory pressure in China. However, looking at underlying economies, emerging markets are not only expected to outpace advanced economies in 2021 and in 2022 but they also proved to be economically more resilient during 2020 pandemic recession(1).
At the same time key uncertainties including strengthening of the USD and vaccination progress are still there but these risks may already be priced in to some extent. EM should catch up in terms of vaccinations as supply is becoming less constrained since developed countries have built their stockpiles.
The regulatory risk in China remains an issue as visibility is limited. Regulation of strategic sectors such as Technology and Healthcare is likely to be extended. China passed data protection law and the draft for the tech sector has also been released. These steps are already impacting Chinese companies but at the same time appear to be more systematic in nature when compared to actions taken earlier. That may remove some of the elevated uncertainty. There may be further challenges ahead but in the long run emerging economies represent an interesting opportunity to capture economic growth.
Emerging markets (EM) are not only different to developed markets but are also diversified within and may be played in several ways. EM Asia, which can be accessed through MSCI EM Asia Index, is the core of Emerging Markets oriented towards Technology and Internet companies. MSCI Emerging Market Index may be viewed as EM Asia with tilt towards commodity driven economies given its exposure to countries like Brazil, South Africa or Russia.
Investors wishing to capture EM economic growth coming from Asia and other regions but with lower focus on China may choose MSCI EM Small Cap index. Finally the S&P Emerging Markets High Yield Dividend Aristocrats Index offers robust cash flow and generous yield. It also allows investors to gain exposure towards more traditional sectors and companies which may benefit most once vaccinations, reopening and recovery accelerate across emerging markets.
Emerging Market Asia
The engine of the global growth likely bolstered by the Regional Comprehensive Economic Partnership and supported by unstretched valuation.
Regulatory risk remains but future changes are likely to be more organized removing some of the uncertainty.
The Engine of the Global Growth
Emerging Markets Asia is the core of the EM representing 78% of the overall capitalization of broader MSCI EM Index. EM Asia is therefore one of the key to understanding developing markets. The region is the engine of the global growth with unstretched valuations. EM Asia economies are already robust and RCEP coming into effect likely early in 2022 could provide additional boost.
Figure 1: EM Asia 12m fwd P/E relative to Developed Equities
Figure 2: GDP growth of EM Asia and Advanced Economies
Year to date underperformance
EM Asia stocks rallied strongly in the second half of 2020 as the robust growth and disciplined approach to COVID allowed most economies to thrive through the crisis. Year to date however, EM Asia lagged developed markets.
Figure 3: Emerging Markets Asia and Global Developed Markets YTD Returns (USD)
Regulatory risk remains but the approach is more systematic
The underperformance was largely driven by China which enacted regulatory measures towards largest internet and technology companies. China unveiled a five year plan to extend regulations over strategic sectors, released a draft of rules to regulate the technology sector and passed a data protection act. These actions are already impacting Chinese companies but at the same time, compared to steps taken earlier, appear to be more systematic in nature, possibly removing some of the elevated uncertainty.
On one hand, the transparency around the regulatory approach remains a key risk, as investors do not have full visibility over either the direction or the execution of those regulations. On the other hand, improved antitrust, data protection and work regulations may benefit the broader market in the longer term by promoting fair competition and equality. Last (but not least) in an environment where fundamentals are strong but single companies may be hampered by new regulations, diversification plays a crucial role.
The largest trade pact in the world bolstering already strong growth
The Regional Comprehensive Economic Partnership (RCEP) signed in November 2020 by China, the majority of EM Asia Countries (excluding Taiwan and for the time being India) as well as Japan, Australia and New Zealand may come into effect as early as beginning of 2022, if ratified. This free trade deal covers around 30% of the World’s economy. In that context it is larger than USMCA or the European Union and will likely provide a significant boost to the economies in the region. RCEP consists of 20 chapters covering not only traditional trade but also areas such as e-commerce and intellectual property. The deal aims to eliminate 92% of the tariffs on goods within the block and if it comes into force, it will bolster the already strong growth coming from the reopening.
Source: Bloomberg Finance L.P., World Economic Forum (weforum.org).
Geographical and Sector Breakdown
The EM Asia Index may seem quite concentrated at first glance. However, from country breakdown perspective China which constitutes almost 44% of the index is well balanced by three countries: Taiwan, South Korea and India which constitute 50% of the index in total. The index is then complemented with companies predominately from Thailand, Malaysia, Philippines and Indonesia. EM Asia is heavily oriented towards technology and Internet companies but the diversification comes from a mix of hardware and software.
EM Asia economic growth is complemented by countries benefitting from elevated commodity prices.
Emerging markets are not only driving global growth but their economies were more resilient than developed market counterparts during the crisis year of 2020.
The GDP drop of only 2.1% in emerging markets vs a 4.6% decline of advanced economies in 2020 is a sign of the resilience of EM which are traditionally perceived as more sensitive to global shocks. The upcoming recovery is also very strong as according to the IMF, by the end of 2022 EM economies will grow by close to 9.5% above 2019, so pre-pandemic levels while advanced economies will be up by 5.2%.
Figure 6: GDP Growth of Emerging Markets and Advanced Economies
EM equity underperformed developed markets year to date by a wide margin and if the pandemic crisis recedes, emerging markets may be well positioned to capture that performance gap later in the year given strong economic fundamentals and undemanding valuation relative to developed equities as presented on figure 8.
Figure 7: Global Emerging Markets and Global Developed Markets YTD Returns (USD)
Figure 8: Emerging Markets 12m fwd P/E relative to Developed Equities
Region and Sector Breakdown
Broad emerging market is EM Asia (78% of the index) complemented with countries from EMEA (14%) and LATAM (8%). EM Asia my allow investors to capture benefits from strong growth bolstered by upcoming RCEP and reasonable valuation. The recent underperformance creates an interesting entry point. For more details on Asia see the earlier EM Asia section in this report.
The EMEA and LATAM components include Brazil (5.3% of the index), South Africa (3.7%), Russia (3.5%), Saudi Arabia (3.1%) and Mexico (1.9%). These countries complement the EM Asia story with a commodity tilt which may benefit investors if prices of raw materials remain elevated. Normalization of monetary policy as seen in Brazil mitigates inflation and hence currency risk.
Figure 9: MSCI Emerging Markets Index Region Breakdown
Figure 10: MSCI Emerging Markets Index Sector Breakdown
EM economic growth coming from Asia and other regions with lower focus on China.
Diversified and strongly performing exposure trading at still undemanding valuation.
Small cap companies in emerging markets performed toe to toe with MSCI World year to date and yet attractive valuation of EM Small Cap remains intact. Undemanding valuation combined with strong growth of EM economies and lower regulatory risk for smaller companies may be particularly appealing to EM investors in the current environment.
Figure 11: Emerging Markets Small Cap and Global Developed Markets YTD Returns (USD)
Figure 12: Emerging Markets Small Cap 12m fwd P/E relative to Developed Equities
Keeping a Low Profile to Avoid the Dragon’s Wrath
Emerging market small cap companies may allow investors to enjoy growth coming from developing economies and at the same time they are less exposed towards regulatory risk as China represents only 9.4% of the index. Moreover smaller companies have generally not been targeted by the Chinese regulator, so far.
In that context, EM small cap may be an interesting alternative as Taiwan, South Korea and India represent in total nearly 60% of the MSCI EM Small Cap Index. Compared to a broad EM Index, EM small cap is more oriented towards semiconductors, chemicals and electronic equipment companies rather than rather than software or pure Internet businesses. More than 1,800 constituents provide the necessary diversification.
Figure 13: MSCI EM Small Cap Index Country Breakdown
Figure 14: MSCI EM Small Cap Index Sector Breakdown
Generous yield and undemanding valuation with risks mitigated by avoiding unsustainable dividends.
Exposure towards more traditional sectors and companies which may benefit if the vaccination, reopening and recovery accelerate across EM.
Robust and sustainable cashflow
In their quest for yield, investors may search Emerging Markets to find cash flow generating companies. However, EM companies may be perceived to be more volatile than their DM counterparts. The cash flow stability and growth may be found within the EM Dividend Aristocrats strategy, comprising companies which have maintained or increased dividend over at least five consecutive years. Within emerging markets this feature is a stamp of corporate development and business resilience.
The S&P Emerging Markets High Yield Dividend Aristocrats Index P/E relative to MSCI World may be appealing for investors given the built-in features of the index which aim to mitigate risks. The strategy excludes companies with unsustainable dividends by applying a 10% dividend yield cap. It also excludes companies with negative EPS to ensure that dividends are better covered by business activities. Against the low interest rate backdrop the forecasted dividend yield of 5.7% is a generous one.
Figure 15: Emerging Markets Dividend Aristocrats 12m fwd P/E relative to Developed Equities
The S&P Emerging Markets High Yield Dividend Aristocrats Index’s more “traditional” sector composition is worth particular attention as sectors such as Financials, Consumer Staples, and Real Estate may benefit the most once the vaccination, reopening and recovery accelerate across emerging markets. Lower exposure towards Technology and Consumer Discretionary partly reduces the regulatory risk for Chinese companies.
China, Taiwan and South Korea represent more than 50% of the index. Compared to the broader EM index, the EM Dividend Aristocrats Index currently overweight UAE (9.9%) and Saudi Arabia (5.7%) at the expense of countries like India and Brazil. It is important to note however that in yield weighted strategies like S&P Emerging Markets High Yield Dividend Aristocrats, country and sector composition may and do change significantly over time.
Figure 17: S&P Emerging Markets High Yield Dividend Aristocrats Index Country Breakdown
Figure 18: S&P Emerging Markets High Yield Dividend Aristocrats Index Sector Breakdown
(1) According to IMF WEO GDP forecasts as of July 2021.
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