To say that 2020 got off to a challenging start for emerging market (EM) equity investors is something of an understatement. Fortunately, the year is ending on a constructive and optimistic note for EM. Economic growth in most EM countries recovered sharply in the latter part of Q2 and in Q3 as stimulus measures took hold and mobility restrictions eased. Positive vaccine news and the US election outcome helped to broaden those gains. EM equities are up than 60% since their lows on March 23.
As we cross the threshold into 2021, there are three considerations that we believe EM equity investors should bear in mind as they look to the year ahead. 1
From a macroeconomic perspective, abundant global liquidity, expectations for fiscal stimulus, and the anticipated recovery in mobility (driven by the prospect of vaccines) promise continued recovery in global growth and global trade. These circumstances are very strongly supportive of emerging market equities through at least the first half of 2021.
The US Federal Reserve’s shift to average inflation targeting has cleared a path for reflation; real rates should remain negative, the yield curve should steepen, and the US dollar should weaken. Most other central banks in developed markets are holding official rates close to zero or slightly negative. Even though many central banks in emerging markets have reduced rates to historical lows, those rates still offer more yield than developed markets. Liquidity, reflation, increased mobility, and improving economic growth were already becoming apparent by mid-year 2020, and the combination of the US election outcome and the better-than-expected timing and outcome of the vaccine trials provided a further catalyst for flows into global cyclical stocks and risk assets, including emerging markets.
We expect the macro backdrop to remain supportive for EM as we head in to 2021, although we remain conscious of potential headwinds in the form of stretched fiscal positions and rising debt levels, especially if economic growth disappoints as the year goes on. In addition, the efforts by central banks to “reflate” may, one day, be successful; this would have implications for rates and equity expectations.
Earnings are likely to drive performance for EM equities in 2021. Since July, MSCI EM consensus earnings expectations have leveled out to around -8% for 2020. Third-quarter EM earnings beat expectations, leading to upgrades in earnings estimates for 2021. EM earnings expectations for 2021 currently stand at 33% estimated growth.
We expect a sizeable recovery in 2021 earnings, although we believe that the 33% consensus earnings growth estimate is probably too optimistic. The current macro environment suggests that a broadening of earnings is likely in 2021, which would support a sizeable earnings recovery for select names in depressed sectors.
The perceived durability of the earnings recovery will be key to supporting multiples over the longer term. It is likely that we will return to an environment of modest global growth at some point in the next few years; however, select companies in a variety of countries with strong business models may provide interesting investment opportunities. For example, e-commerce companies (falling in the consumer discretionary sector), media and entertainment companies (in the communication services sector), and technology companies should continue to deliver attractive long-term earnings growth as they become structurally more important to consumers and businesses. We believe quality growth will continue to provide attractive investment opportunities in this environment, but valuation will matter – and stock selection will matter.
We focus on investing in quality growth companies, so a broad-based, more cyclical rally that favors value relative to growth, much like the rally the markets experienced in November, could set us back in the short term. The current macro backdrop suggests that the rotation toward more cyclical sectors may be relatively durable, leading to a value-driven rally that could last for months, not just weeks. For EM equity investors, outperformance during a more durable cyclicals rally may come from laggard sectors such as energy and financials, and from laggard countries such as Brazil, Russia, and Thailand.
Despite this possibility, we believe the long-term 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 may prompt us to trim exposure to some names, but we are likely to maintain overweight positions to our highest-conviction stocks in these sectors. Excess capacity and deteriorating returns are likely to continue to plague traditional value segments. We will look to add more exposure to quality cyclical stocks with sustainable earnings growth. For example, we have increased exposure to quality banks and continue, as always, to look for new opportunities.
We believe that EM investors should consider three main points as we move into 2021: the macroeconomic environment, earnings potential, and the possibility of a more durable rotation to value. The macroeconomic backdrop – characterized by abundant global liquidity, expectations for further fiscal stimulus, and the promise of improved mobility enabled by new vaccines – should support continued recovery in emerging markets. Earnings recovery will likely drive returns and performance in EM equities. 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. And finally, although a more durable rotation to value is possible in light of the current macro backdrop, we’re likely to maintain overweights to our highest-conviction choices in these new-economy sectors. At the same time, we’ll look to add exposure to quality cyclical names with sustainable earnings growth, in our continuing quest for equity opportunities in emerging markets.
1We recognize that uncertainties still exist and though our forward-looking visibility has improved it still remains constrained by macro and idiosyncratic factors. This outlook will need to be revised frequently as data and changed expectations dictate.
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