Answers to the Top Five Questions About Emerging Markets Today
Emerging market (EM) equities have rebounded by more than 40% from the lows reached in March, due in large part to the tremendous monetary and fiscal stimulus in both developed and EM countries. While we all await clarity on a potential second wave of COVID-19, the timing of vaccine development, and the outcome of the US election, we’d like to discuss five questions that are shaping our thoughts on EM equities right now.
1. How robust and sustainable will the post-pandemic economic recovery be?
We are already seeing economic activity recover as economies re-open from pandemic-induced shutdowns. The decline and rebound in financial markets have been both sharp and swift, allowing for hope that economic recovery will follow the same path. It is likely too soon to tell just how robust and sustainable the recovery will be at this point, as damage to some parts of the economy will be lasting or even permanent. Moreover, the risks of a second wave of COVID-19 in the fall could imperil recovery trajectories and stimulus efforts.
The size and breadth of monetary and fiscal stimulus implemented in the wake of the crisis, globally, is unprecedented. The IMF forecasts shown in Figure 1 suggest sharp economic recovery in 2021, setting real GDP growth firmly back in positive territory. While this is good news, we still do not have much visibility into the sustainability of growth beyond that point. It is also important to keep in mind that not all emerging markets are the same, and that high economic growth doesn’t always translate into great equity performance. A strong rebound in economic activity will naturally turn the spotlight toward economically sensitive companies. Further, the extent to which interest rates increase will begin to diminish one of the favorable catalysts behind the strong performance of growth stocks.
2. Will EM policymakers be able to tighten monetary policy and tackle large fiscal deficits when economic conditions improve?
Not all emerging markets are alike, and not all emerging market policymakers responded to the economic crisis in the same way, with the same policy tools, or to the same degree. They all did, however, respond in the same direction by providing fiscal stimulus, lowering official rates, and freeing up liquidity in banking systems. The difference for emerging markets in this crisis, compared to past crises, is that EM policymakers were able to lower rates along with policymakers in advanced economies. In some cases, EM central bankers were able to use policy tools such as quantitative easing (QE) that were once only accessible to advanced economies. EM policymakers also announced fiscal stimulus packages of varying sizes and shapes.
Because recent EM policy responses contrast with those that were afforded to EM in the past (e.g., higher rates, tighter fiscal policy to thwart capital outflow and currency weakness), we expect to see EM economic growth recover more quickly, but at the cost of higher fiscal deficits and potentially higher inflation. In some countries, this may lead to sharp upward adjustments in interest rates. Countries with strong institutions and credible policymakers should be best suited to normalize policy when conditions improve.
3. How supportive will a weaker US dollar be for emerging market equities?
The correlation of the US dollar index to EM equities tends to be quite solid. A decline in the value of the US dollar has historically provided a tailwind for EM equities and other riskier asset classes. We believe this remain the case going forward; however, the tailwind in not likely to be strong for three key reasons. First, as Figure 2b shows, rates in EM are currently at or very close to their lowest levels in history. In the wake of all past crises, interest rates in EM were higher and more attractive to both fixed income and speculative capital flows. In other words, FX “carry” was attractive. This is not the case now.
Also, large fiscal stimulus packages increased fiscal deficits and, ultimately, debt levels. In some cases, this debt is being monetized. This, too, will exert pressure on some EM currencies, preventing them from strengthening.
And last, the correlation between US dollar weakness and EM equities was, in part, due to the commodity and materials component of EM – a part that has decreased not only in size in the EM index, but also in relevance to the expected economic recovery. In the past, infrastructure spending played a big part in economic recovery, especially in China. Infrastructure spending in China and other countries is now less commodity- and materials-sensitive and more technology-driven (think 5G, cloud).
4. Are emerging market earnings expectations for 2021 achievable?
MSCI EM consensus earnings growth expectations for 2020 at the end of 2019 were about 15%. At the time, 15% seemed a bit high but still reasonable because of an expected rebound in earnings from the large semiconductor manufacturers, whose 2019 earnings contraction was responsible for EM’s negative earnings growth that year. The pandemic and following economic lockdowns erased all hopes for positive earnings growth in 2020. We are, however, beginning to see earnings, on balance, come in slightly better than feared, though still likely to be down in the range of 6-8% in 2020. Earnings growth expectations for 2021 are quite high at 30%. We expect a sizeable recovery in 2021 earnings, but we would be inviting a fair amount of disappointment if we believe the 30% 2021 consensus earnings growth expectation to be realistic at this point.
While 2021 earnings growth will be important, the perceived durability of the earnings recovery will also be a critical factor. It is likely we will return to the mode of modest global growth; however, select companies in a variety of countries with strong business models will provide interesting investment opportunities. Stock selection will matter.
5. How worried should we be about a broad-based, indiscriminate rally in which EM value outperforms EM growth?
The EM Equity Select strategy looks to invest in quality growth companies, so we will always worry about a broad-based, indiscriminate rally that favors value over growth. At first glance, the EM growth-versus-value performance chart in Figure 5 suggests that we should be very worried.
Our 2019 paper titled “EM Equities: No Longer Only Beer, Banks and Cement” highlighted the changing composition of the sectors and stock in the EM benchmark. The weights of sectors such as energy, materials, and traditional telecommunication services – which include much of what makes up “value” – have been halved over the past ten years, while the weights of technology and consumer discretionary have more than doubled in size. These new-economy sectors are where we find quality growth stocks in semiconductor manufacturers, internet and gaming companies, as well as e-commerce. The COVID-19 pandemic has reinforced the trend toward e-commerce as well as the demand for internet, gaming, and healthcare. We continue to believe strong business models generating growth favorable to the benchmark at reasonable valuations will generate above-average returns over time.
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