Five Trends Shaping Our Emerging Markets Equity Portfolios
So far this year, the backdrop for emerging market (EM) assets has changed from supportive to challenging as a stimulus-driven recovery is forcing investors to re-think positioning and re-price assets that benefit from growth and reflation. One key difference for emerging markets now is the notion that the US economy is poised to take over the lead role in the global recovery; US monetary and fiscal policy are set to remain expansionary this year and next, while China monetary and fiscal policy will remain more restrained.
Stronger US economic growth, as well as higher inflation relative to the rest of the world, put upward pressure on US interest rates and the US dollar. This tightens dollar funding costs, forcing EM rates higher and pressuring EM currencies lower. We do not expect a repeat of 2013’s “taper tantrum” across EM countries broadly; however, policy credibility will be a key differentiating factor across EM countries. There are still investment opportunities to uncover in EM equities, though the current challenges serve as a reminder of the risks. As we look forward to the coming weeks and months, here are our thoughts about five topical issues that are shaping our current EM equities portfolios.
1. Economic Growth Beyond the Stimulus Driven Recovery Will Vary Substantially by Country
Last year’s COVID-driven economic crisis prompted significant monetary and fiscal policy responses from both developed and emerging market countries. In turn, many countries experienced some of the fastest “V-shaped” recoveries in history. Despite all this, some countries will struggle to deliver economic growth in 2021 that puts them much above 2019 levels. Expectations of a strong, synchronized global recovery are fading in the face of new COVID waves, slower-than-hoped-for vaccine roll-outs, and divergences in economic policies and growth expectations, especially between the US and China.
Ultra-expansionary monetary and fiscal policy in the US differs from a more restrained policy in China, fueling expectations for stronger US growth relative to China. (See Figure 1a.) Rising global economic growth and trade are positive for EM countries; however, as the US moves into the lead relative to China and the rest of the world, the potential for higher US rates and a stronger US dollar will create a headwind for many EM countries. (See Figure 1b.)
Figure 1a: Economic Growth Beyond the Pandemic Will Vary Greatly by Country
Real GDP Growth Expectations for 2021 and 2022
Figure 1b: US GDP Recovery Will Be Stronger Relative to China in 2021 and 2022
US and China Real GDP Growth and the Difference
2. The Risk of a “Taper Tantrum” Has Risen; However, Many EM Countries Have Healthier Balance-of-Payments Positions Now
In 2013, the US Federal Reserve was preparing to taper its bond purchase program, effectively tightening monetary policy. While tapering is not the case today, the US Fed’s Average Inflation Targeting policy framework leaves US long rates “unanchored,” allowing the market to price-in the risk of higher inflation. The likelihood of higher inflation and strong growth prints in the US over the next several months will keep upward pressure on interest rates and the US dollar, pulling up rates across the globe.
Many EM countries are in a better position today – with smaller current account deficits and weaker exchange rates – than they were in 2013. (See Figure 2a.) Rising US rates will still create a strong headwind (or worse) for some EM countries, as many EM countries will need to raise rates from today’s low levels to deter capital flight and prevent currency depreciation. Despite healthier balance-of-payments positions for many EM countries today, policy credibility and a focus on reform will be key differentiators in the months ahead – because investor sentiment is an important driver of continued investment flows into EM. (See Figure 2b.) For the third time in less than four years, Turkey has provided a fresh reminder of the cost of policy missteps – capital flight sending Turkish stocks and lira lower, and rates and spreads higher.
Figure 2a: External Vulnerability Is Reduced for Many Countries, Though it Remains Problematic for a Few
Short-Term External Debt as % of Foreign Exchange Reserves, 2020 vs. 2012
Figure 2b: EM Currency Stability and Strength Are Reliant on Strong Investment Flows
EM Currency 3-Month % Change and Total Portfolio Flows to EM 3-Month Sum
3. Inflation Pressures Are Rising for Some EM Countries, Marking the End of Historically Low Rates
Despite large output gaps in many countries around the world, the rise in headline inflation and possible second-round passthrough is real for many EM countries. Higher inflation pressures may create a growth and liquidity headwind for many EM countries as central banks will be forced to reverse, at a minimum, their emergency rate cuts from last year. Most EM central banks still do not have the ability to wait out what may be a transitory rise in prices, as many are much more sensitive to rising food prices than developed countries (on average, food comprises about 30% of the typical EM inflation basket).
Official benchmark policy rates are at or just slightly above historical lows, and some central banks, such as Brazil and Russia, have already started to raise rates. (See Figure 3a.) Again, policy credibility, both monetary and fiscal, is key because of the need for continued economic recovery amid higher deficit and debt levels, potentially weaker currencies, and possible portfolio outflows. Rising rates will increase the cost of capital for both countries and companies, making deficit and debt levels costlier to finance. (See Figure 3b.) Continued economic recovery, combined with policy credibility and reform, is key to maintaining investor confidence and avoiding a reversal in sentiment that results in capital flight.
Figure 3a: EM Central Banks Will Start Lifting Rates from Emergency Levels
Range of Official Benchmark Policy Rates and Current Policy Rate
Figure 3b: High Debt and Deficit Levels Will Become More Challenging as Interest Rates Rise and Growth Slows
General Government Deficit and Debt Levels as % GDP
4. We Expect a Strong Commodity Cycle, but Not a Super-Cycle
The rise in commodity prices as the world recovers from the shock of the pandemic is unsurprising. (See Figure 4.) The pandemic created supply disruptions and bottlenecks from agriculture to mines, while OPEC+ reduced production levels and pushed energy prices higher. Generally, increased demand pressures are beginning to surface from economic recovery, stemming from increased mobility, restocking, climate initiatives, the potential for large US infrastructure stimulus, as well as financial demand for commodities as inflation hedges. In our view the current recovery in commodity prices and the supportive backdrop for commodity prices makes this a commodity cycle, not a super-cycle.
The most notable commodity super-cycle in recent history (2000-2014) was driven primarily by China’s entry into the WTO and the country’s massive push to industrialize and urbanize. China’s infrastructure investment today is more about technology, digitization, and climate and less about roads and bullet trains. The US administration just released details of the first part of a two-part proposed infrastructure plan that includes modernizing transportation and power infrastructure, building green housing and schools, and rolling out high-speed broadband. This $2.2tn package is good example of how today’s definition of infrastructure has shifted to include enhanced technology, digitization, and “green” investment alongside traditional infrastructure investment in roads, bridges, and rail.
We do expect commodity prices to remain well supported throughout this year and next – the supply-demand mis-match for commodities such as crude oil will exist for some time. As mobility and travel rebound closer to pre-pandemic levels amid sustained OPEC+ production cuts, supplies will be drawn down, leaving the market in deficit and propelling crude oil prices higher. Demand for “green” commodities such as copper, cobalt, and lithium should also remain well supported for some time. The upward price pressures for some will be tempered by downward price pressures for other commodities as the global economic recovery shifts demand from manufactured goods to services.
Figure 4: Commodity Prices Have Risen Sharply from 2020 Lows, Marking the Start of a Commodity Cycle, Not a Super-Cycle
IMF World Commodity Price Index
5. Quality Growth and Cyclical EM Companies Will Win in the Long Term
The continued recovery in global economic growth, along with the expansionary policy in the US and other advanced economies, should enhance and extend the duration of the reflation-driven rotation to cyclical assets through most of 2021. Despite this, we believe the secular and structural advantages for new-economy growth stocks in certain sectors – including information technology, communication services, and consumer discretionary – will lead them to outperform in the long term. Rich valuations amid rising interest rates have prompted us to trim exposure in some names, but we are likely to maintain overweight positions to our highest-conviction names in these sectors. Excess capacity and deteriorating returns are likely to continue to plague traditional value segments once the reflationary impulse fades. In the meantime, we expect to maintain our current increased exposure to quality cyclical stocks with sustainable earnings growth.
We are mindful of the impact higher US economic growth relative to China and the rest of the world may have on higher-valuation EM companies, as well as the headwind this may create for EM as a whole. The current valuation of EM growth is significantly above its 10-year average and has pulled MSCI EM higher as well. The current valuation of MSCI EM Value, while lower than MSCI Growth, is also above its 10-year average level, though not to the same extent as MSCI EM Growth. (See Figure 5a.)
EM earnings growth expectations are 37% for 2021 and 16% for 2022, with expectations for cyclical and value companies’ contributions to the total increasing. Earnings growth for 2021 is expected to be driven by a combination of companies such as Samsung Electronics (which will benefit from chip shortages and the positive DRAM cycle), Chinese internet giant Tencent, old-economy natural resources company Vale in Brazil, and several large Chinese banks. Current valuations on our highest-conviction new-economy growth stocks are reaching attractive levels, with both ROEs and ROAs on many of these names supportive of our longer-term earnings growth expectations. (See Figure 5b.)
Figure 5a: The Valuation of EM Growth Remains High Relative to EM Value, but EM Value Is Not “Cheap” Relative to its 10-year Average
MSCI EM, MSCI EM Growth, and MSCI EM Value Trailing Price to Earnings with Averages Since 2011
Figure 5b: ROEs and ROAs Remain Supportive of EM Growth Outperformance Once the Reflationary Impulse Fades
Return on Equity (ROE) and Return on Assets (ROA) for MSCI EM, MSCI EM Growth, and MSCI EM Value
These are just a few of the trends being discussed by emerging market equity investors today. Global recovery and reflation are likely to continue, prolonging the rotation into cyclical assets; however, stronger growth and rising interest rates in the US relative to the rest of the world create headwinds for emerging markets. Over the longer term, we believe companies with strong business models in the e-commerce, media and entertainment, and technology spaces will be most likely to deliver attractive long-term earnings growth. In the near term, we expect to maintain an elevated exposure to quality cyclicals with promising earnings growth potential.
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