International | Feb 17 2021
While traditional structural issues may weigh on some investors, many others seek out emerging markets for a core holding, by virtue of sheer size and growth prospects.
-Current investment thesis for emerging markets
-The potential for a global synchronicity tailwind
-Will traditional structural issues impact?
By Mark Woodruff
Emerging markets (EM) are considered a core allocation for many investors seeking long-term growth.
In aggregate, emerging market economies account for around 50% of global economic activity (GDP) and contribute 75% of global economic growth. In looking ahead to 2040, it is estimated that EM economies will have an output that is more than double that of the developed world.
These markets have experienced dramatic growth and transformation over the last three decades. The emerging market investment universe used to represent a mere 1% of the global equity market in the late 1980s, and now accounts for around 11%.
Over time the asset class has evolved and now Asia dominates EM in terms of economic growth, consumption and trade. Within the benchmark MSCI Emerging Market Index, Asia’s representation currently comprises more than 75%, with the increasing inclusion of China’s domestically listed A-shares driving changes in benchmark weights.
This shows an EM investment is very much a play on Asia, and indeed China, which comprises 43% of the benchmark. The next largest EM countries are Taiwan which accounts for 13% of the index, South Korea 12% and India 8%, while the residual 24% is a long tail of smaller markets led by Brazil at 4%.
Some of above percentages can be misleading as South Korea and Taiwan play an outsized role in the index relative to the size of their economies. Other countries are poised to grow, and the drivers of that growth within EM are changing.
New sources of growth include industry leaders in innovation, which is occurring in areas such as communication services, retail, entertainment and digital platforms. Healthcare is also moving to the fore and becoming a larger part of the opportunity set. From a sector perspective, consumer discretionary at 22% is the largest sector in EM, followed by IT at 18% and financials at 17%.
Asian consumers are driving video streaming, e-commerce and other forms of digital consumption. These are growing rapidly alongside other forms of service-driven consumption.
In Part I of this article, FNArena explores the current investment thesis for emerging markets and what traditionally drives or inhibits their performance.
Part II of this article looks at currency and equity opportunities, within separate emerging market countries. The aim with equities is to identify those industries, sectors and companies that should benefit from tailwinds.
While China is covered in this article, FNArena considered the country warranted separate and more detailed attention, given the country’s size relative to the benchmark index.
See Are Chinese Shaes A Unique Opportunity? (https://www.fnarena.com/index.php/2021/01/29/are-chinese-shares-a-unique-opportunity-part-i/)
Before going any further, let’s examine what defines an emerging market and who are the EM member countries.
EM countries are those that are striving to become advanced countries, and are generally on an economically disciplined track to become more sophisticated. This includes increased fiscal transparency, a focus on production, developing regulatory bodies and exchanges and acceptance of outside investment.
Although some large countries like China and India have high production and industry, other factors like low per capita income or a heavy focus on exports qualify them as being within EM.
According to the Morgan Stanley Capital Emerging Market Index, 24 developing countries qualify as emerging markets. These include China, Taiwan, South Korea, India, Brazil, Russia, Indonesia, Malaysia, Greece, Hungary, Mexico, Pakistan, Chile, Colombia, Czech Republic, Egypt, Peru, Philippines, Poland, Qatar, South Africa, Thailand, Turkey, and United Arab Emirates.
At times this article will refer to Asia Pacific (APAC) which includes East Asia, South Asia, Southeast Asia, and Oceania. Clearly there is a great deal of geographical crossover and some differences between APAC and EM constituent countries. The reader should bear in mind that the likes of Australia, Hong Kong, Singapore and Japan, while included in APAC, are not EMs.
Complicating matters even further, broker research often refers to EEMEA. This stands for Eastern Europe, the Middle East and Africa. This incorporates countries such as Russia, Greece and Hungary for example, which are also captured within the EM definition and includes many countries that are not.
The current investment thesis
Wilsons Advisory sees a clear inflection point for the global and EM growth cycle extending at a minimum through 2021 and 2022. The covid-19 situation is now improving in a broad range of emerging markets and their recoveries are gaining momentum.
In 2021 the effect of global vaccine rollouts, ultra-low interest rates and a weaker US dollar should lead to a sharp rebound in EM growth.
Morgan Stanley agrees that EM growth will rebound sharply in 2021 for the reasons cited by Wilsons. They also believe growth will be aided by a widening US current account deficit and the accommodative domestic macro policies of EM (ex China).
The vaccination of the vulnerable population (and not the higher bar for achieving herd immunity) will be the key for reopening the economies, along with the advent of rapid testing. The reopening of economies will even extend to include the covid-19-sensitive sectors.
After a prolonged period in which EM countries have faced a series of cyclical challenges, the Morgan Stanley feels macro stability is now in check. With the covid-19 situation improving in a broad range of EMs, their pace of recovery is catching up.
Adding to the impetus, the pace of the China growth recovery has been impressive with China already surpassing pre-covid-19 levels of economic activity. This, in combination with a period of above-trend growth for the global economy, should assist EM growth.
DBS Group also suggests Asia’s success in dealing with the pandemic will pave the way for relative economic and financial outperformance in 2021. Pandemic management is not the only reason behind the optimism. Three additional factors support the Singaporean financial services group’s thesis.
Firstly, regional trade intensity has risen as the world requires substantially more remote work and education, medical supplies and home improvement.
Asia stands ready to meet the global craving for screens, computers, sound equipment, PPEs, computer desks, home gym gear etc. Already the pick-up in export demand is visible in the region’s purchasing managers indices (PMIs). It’s also evident in the order books of electronics and a wide range of consumer goods exporters.
The second reason for likely outperformance is the relatively high levels of foreign exchange reserves, savings and investor participation in the region.
DBS doesn’t see the markets worrying about debt or current account sustainability in the region next year. In fact, there’s expectation for a great deal of interest among external investors to pick up Asia’s positive yielding bonds and high growth stocks. They also cite investor interest in gaining exposure to regional currencies that are likely to appreciate or remain stable.
The final reason for outperformance is that China will enter 2021 with a tailwind, having made up for the pandemic-induced loss in output. The APAC region presently has deeper trade and investment ties with China than ever before. DBS forecasts that the country is looking at 7% growth in the coming year.
This is further buoyed by sentiment-improving initiatives like asset market liberalisation, the Regional Comprehensive Economic Partnership (RCEP) free trade agreement and the e-RMB (Chinese crypto). The reader may be aware the People’s Bank of China will be the sole issuer of the digital yuan, initially offering the digital money to commercial banks and other operators.
This potential Chinese growth is considered partly due to the country enjoying strong domestic travel and production. In addition, some dissipation of the tension with the US as the Biden administration gets started will assist growth.
Trade war – from headwind to tailwind
The impact of the US-China trade war on the entire Pan-Asian region is perhaps best seen in the relative performance of equity markets over the last couple of years.
With US President Donald Trump increasing tariffs against China from the start of 2018, the MSCI Asia Pacific Index underperformed the S&P500 index over the subsequent two years by approximately -30%. Over this period, global investor appetite for emerging markets and Asian equities dropped materially due to the drag on potential portfolio performance.
The relevance of the win by President Biden and the Democratic Party in the 2020 US election should therefore not be underestimated for Pan-Asian equities. Current Democratic Party policy statements appear to place less emphasis on unilateral actions against China (e.g. tariff escalation), and more on US domestic policy, particularly given the need to support the US economy out of recession.
Longlead Capital Partners see the election of President Biden as leading to a period of greater predictability with respect to US-China geopolitics. Contentious issues such as intellectual property protection for US companies will likely remain sources of tension between the countries, however the impact of such negotiations is likely to be far less material for listed Pan-Asian companies.
Already there are signs that sentiment is improving towards Pan-Asian equities, with tariff risks taking on a lower level of importance for the region, and recent performance suggestive of an ongoing catch up underway.
Longlead awaits the decision of a Biden administration with respect to existing tariffs. It remains a possibility that trade becomes a tailwind for Pan-Asian equities in 2021, and not the headwind of the past few years.
Is there evidence of global synchronicity?
A global synchronous recovery, with both developing markets (DM) and EM growth accelerating in the same year, has taken place about 12 times over the last 40 years, the last one in 2017.
As it is a relatively common occurrence, it’s beholden upon us to examine how DM economies are performing, as a potential indicator of the future for emerging markets.
Morgan Stanley forecasts global growth of 6.4% for 2021, which is above 5.4% consensus expectation. Despite the sharp gyrations in economic output over six quarters, the global economy is estimated to return to the path it would have followed absent the covid-19 shock.
This projection stands in stark contrast to the consensus, which worries the pandemic will have a bigger impact on private sector risk appetite and hence global growth. However, consumers have driven the recovery so far and investment growth (a reflection of the private corporate sector’s risk tolerance) is bouncing back as well.
Morgan Stanley notes the pandemic shock was exogenous, private sector balance sheets and the financial system were in good shape coming into this recession, and we had a policy response that was timely, coordinated and sizeable.
The combination of these three factors meant that private sector risk appetite, which is crucial in any recovery, has remained relatively healthy.
Moreover, even as economies are well on their recovery paths, policy-makers are keeping extremely reflationary policies in place as they try to mitigate the impact on unemployment.
Morgan Stanley’s US economists highlight that large fiscal transfers and lower spending (constrained by lockdown measures) in the initial months of the pandemic have led households to run up large amounts of excess savings.
Relative to the pre-covid-19 baseline, households had saved an extra US$1.2 trillion as of September 2020, which translates to 8.5% of 2019 personal consumption expenditure (PCE ) levels. This savings buffer should provide an additional cushion for consumer spending in the coming months.
To an extent a similar dynamic is also under way in Europe, and Morgan Stanley expects consumer activity to surge again once restrictions are lifted.
The investment bank expects a broad-based recovery, both by geography and sector, to take hold from March/April onwards. Driving this synchronous recovery will be a more expansive reopening of economies worldwide and the extraordinary monetary and fiscal support now in place.
Global GDP, already at pre-covid-19 levels (based on seasonally adjusted GDP levels), continues to accelerate and is on track to resume its pre-covid-19 trajectory by the second quarter 2021. The broker expects the US to return to its pre-covid-19 level by the fourth quarter.
Capital expenditure to take over the running from the consumer
A key feature of any self-sustaining recovery is the capex cycle, and Morgan Stanley expects a vibrant capital expenditure (capex) cycle to follow. While consumers have been leading the recovery so far, the damage to the capex cycle has not been as bad as feared.
A continued recovery in consumption and the fact that private sector risk attitudes are healthy mean that the bank expects a vibrant capex cycle to kick off from the second quarter of 2021.
The bank is already seeing some early signs of a pick-up in capex. High-frequency indicators including capital goods production and imports are bouncing back in a similar fashion as aggregate economic activity.
It’s instructive to look at US and Asia, where recoveries are arguably more advanced than other economies.
US capex plans have risen to their highest level since August 2019 and core capital goods orders are running ahead of shipments. This suggests a revival in business capex is already under way.
In China and other trade-dependent economies, stronger external demand conditions should also lead to a rise in capex, particularly in the private manufacturing sector.
Indicators show recovery already underway in Emerging Markets
EM (ex China) initially lagged the recovery and is now catching up, according to Morgan Stanley. The covid-19 situation is improving across a large swathe of individual emerging markets, allowing policymakers to reopen their economies further, even before a vaccine was available.
Trade-dependent economies like Korea and Taiwan are already well into their recoveries. A number of indicators for the large, more domestic demand-oriented economies like India and Brazil, have recently exceeded pre-covid-19 levels and are registering positive year-on-year growth.
China’s real retail sales are now growing by 2.4% per annum, while Brazil’s real retail sales were 7.7% above pre-covid-19 levels in September 2020. Auto sales in India were also growing by 20%.
This strong momentum should continue into 2021, with EM growth rising to 7.4%, higher than the consensus expectation of 6.3%. In particular, Morgan Stanley has a more constructive view on Asia ex Japan and Latin America as compared to the consensus.
EM real exports were already growing on a year-on-year basis in September 2020, helped by a recovery in end demand in key markets and the restocking cycle. These external demand conditions are likely to remain supportive, Morgan Stanley, helped by improving demand in the US and China.
How do domestic policies in both the US and China impact upon emerging markets?
In combination with easy monetary policy, fiscal stimulus will remain an active policy tool in 2021 (and likely beyond) in the US, forecasts Morgan Stanley.
These reflationary policies will also have key implications for global growth, and especially for emerging markets, because of a shift in the savings-investment balance.
In contrast to the last cycle, a rise in government deficits will not be offset by increased domestic saving in the private sector, particularly households, for two reasons. Firstly, households do not face the same deleveraging pressures as they did coming out of the GFC. This is evidenced by private debt/GDP ratios having remained stable for some time. Secondly, low interest rates provide little incentive for households to save, explains the investment bank.
The resulting widening of the current account deficit, which occurs when a country spends more on imports than it receives on exports, will be another factor driving the US dollar down.
Continued low real rates and a widening US current account deficit will provide a reflationary impulse for the rest of the world, especially EMs. This is because EM economies are likely to benefit most from the increase in import demand, as they account for roughly two-thirds of the US trade deficit.
Chinese infrastructure and manufacturing spend to lift wider EM
Given China’s relative size, its economic health has a strong impact on other Asian economies. Strategists at DBS Group highlight how Indonesia, Malaysia, South Korea, and Taiwan benefit considerably from the China growth dynamic.
China will maintain policy support in the near term as policymakers are working on restoring health to the labour market. China’s credit impulse has reached its highest level since mid-2016. This will especially impact upon infrastructure spending, which will flow through to other EM economies in the coming quarters, notes Morgan Stanley.
Moreover, private consumption is expected to bounce back sharply in 2021 as households gain confidence and will begin to draw down their precautionary savings. The availability of a vaccine will lead to the full resumption of contact-based activities, providing a fillip to consumption growth.
Favourable external demand conditions should also translate to a rebound in private manufacturing sector capex, meaning that private sector activity looks set to recover in a fully-fledged manner.
Lower-for-longer EM interest rates
Morgan Stanley presents a compelling rationale as to why interest rates can stay low for longer than usual in EM, thereby heightening the impact of monetary policy. Ultimately, this should be reflected in a pick-up in domestic credit demand.
Traditionally, external pressures have cut short EM easing cycles. This time around, with the Federal Reserve on hold for the foreseeable future and the outlook for a weaker US dollar, EM central banks will face little pressure to raise rates to protect the exchange rate or prevent foreign capital outflows.
While conceding structural issues linger in the background, Morgan Stanley believes they are not likely to be constraints on the cyclical recovery. In addition, a cyclical recovery will actually help to alleviate some pressures, such as on public finances, as tax revenues rebound alongside nominal GDP growth.
Caution on EM debt levels
On the severity of structural issues, JPMorgan begs to differ, based on concerns over EM debt levels. The covid-19 shock has led to the largest annual increases in both EM government and private sector debt as a percentage of GDP. They are now at new all-time highs.
JPMorgan concedes governments needed to respond to this health crisis with fiscal support, and future debt levels may have been worse had they not done so. However, it’s considered the overall levels of debt across EM will leave a legacy that market participants will be grappling with through the next cycle.
Defaults in 2020 were mostly due to previous debt build-ups, rather than debt caused by the pandemic itself, explains the investment bank. Given EM government debt levels were already elevated in some countries coming into this crisis, the EM sovereign bond default rate reached a 20-year high in 2020.
EM private sector credit to GDP has also increased to an all-time high. At 147% of GDP, emerging markets private sector credit to GDP is now around developing markets averages of 161%. However, China has a large impact on the overall level given its very high levels of debt. EM (ex China) is only 90%, notes JPMorgan.
EM debt increases over the past year have been driven by corporate domestic loans rising, with household debt also increasing, but to a lesser extent. The international EM corporate bond market is small compared to the EM private sector debt stock. That does not mean investors should ignore the risks that this large debt stock may leave for EM countries.
Some of the large EM countries will be left with large debt levels dominated by local debt. Steepening curves in Brazil and South Africa reflect this concern, concludes JPMorgan.
Oxford Economics is similarly concerned, and believes a timid fiscal response to the pandemic threatens to entrench weak demand and low inflation, which should keep bond yields low for most emerging markets. While a large-scale EM funding crisis will likely be averted this year, a large debt burden means vulnerabilities will remain.
On balance, Oxford believes EM governments have probably erred too much on the side of fiscal caution amid fear of market reaction. EM fiscal packages have been less ambitious than those of advanced economies, despite the larger downward revisions to activity of EM countries.
EM funding needs are considered colossal, but there is evidence of easing funding conditions for most. EM countries remain broadly on track to issue enough bonds to meet 2020 needs and Oxford Economics sees limited evidence of funding snowballing into shorter maturities.
Varying debt concerns by country
Despite Asia Pacific (APAC) leading the global recovery from the pandemic, the overall positive trend masks noticeable divergences within the region. Research by Oxford Economics shows APAC’s robust growth is built on the strong performance of a handful of economies, whereas others are still struggling with virus-related setbacks.
Northeast Asia continues to lead the recovery within the region, while India’s GDP was still expected to be -8% below the pre-pandemic level for the fourth quarter 2020.
In Asia, DBS Group notes that corporate bond defaults were far smaller than in the US. Hong Kong and Korea remarkably saw no defaults, while India and Indonesia reported a lower quantum of defaults compared to 2019.
Robust loan growth in North Asia and a greater reliance on bank financing in South Asia, supported by loan moratoriums, have helped Asian firms tide through this difficult period better, explains DBS.
China was the outlier in Asia as corporate bond defaults rose by over 50% in 2020. However, this accords with a fast-growing bond market, with the ratio of defaults to maturing bonds having in fact eased from 2019. Nevertheless, a rise in state-owned enterprise (SOE) defaults mean investors should stay cautious on Chinese SOEs that are heavily leveraged and marginally profitable, cautions DBS.
Markets are becoming more judicious in assuming the availability of local government support, with the government having declared that it will foster more market-based credit decisions.
China’s real estate sector is a particularly key credit market driver, given a large proportion of Chinese developer credits, and high leverage in some firms.
The pandemic has fallen unevenly across different sectors and different parts of the labor force, and the same is seen in Chinese residential sales. Eastern China is slated to record its fastest annual sales growth since 2016, while Central and Western China will see their worst growth, outlining truly divergent real estate credit risks by geography.
For India, the bond market has been through a wrenching journey due to a prolonged credit crunch for non-banking financial companies (NBFC), explains DBS Group. However, credit stress is now considered nearer the end than the beginning.
Incremental new bond defaults in 2020 are close to India’s pre-crisis average. While moratoriums have helped to staunch cash flow difficulties, subdued new defaults do give reason to hope that most non-performing assets are already weeded out.
Meanwhile, the largest Indian private sector banks have also raised their capital buffers to ample levels, supported by a stirring equity market. DBS believes Indian credit may finally enter a more confident phase in 2021. This is provided asset quality outcomes meet expectations, covid disruptions subside and India’s sovereign rating is held steady at investment grade.
Oxford Economics utilises an in-house funding vulnerability scorecard. This places South Africa and Brazil at the most vulnerable end of the spectrum given their large fiscal measures and high financing needs. The scorecard also highlights countries that are behind track in terms of the required bond sales this year (Philippines, South Africa, Malaysia) and those with shallow domestic markets (Indonesia, Mexico).
Warning of potential contagion
Despite the likelihood of relative outperformance, Asia does not exist in a vacuum. Many developing economies are in precarious positions, weakened by the economic cost and social toll of the pandemic, notes DBS Group.
Several economies in Africa, Latin America, and Middle-East could see deep economic contraction and financial crisis next year, weighed down by debt, funding deficit, and loss of investor confidence.
Low rates and ample liquidity could cause housing prices to soar, as well as push the valuation of a wide array of financial assets. These trends will inevitably accentuate inequality in many parts of the world.
Prosperity is not necessarily progress. A rise in the stock market, an increase in housing wealth and a steady increase in average income can mask several downsides. These include rising inequality, anxiety about future job prospects, burden of debt, health and education outcomes and social cohesion.
Debt will loom large, and financial sector stability may be undermined as frothy valuations have their comeuppance, cautions DBS Group.
Three risks to the positive EM scenario
Firstly, the scenario around the trajectory of the virus may worsen or there are adverse vaccine developments or delays.
There may also be some uncertainty around the fiscal policy path. Political gridlock may prevent fiscal stimulus, leading to downside for Morgan Stanley’s growth forecasts.
The final risk is the flip side of the second point mentioned above. There may be a quicker-than-expected inflation overshoot (compared to Morgan Stanley’s base case), leading to a disruptive shift in Federal Reserve policy expectations.
The key issue for inflation is the uncertainty around the natural rate of unemployment in this cycle. If the accelerated restructuring of the economy means a higher non-accelerating inflation rate of unemployment (NAIRU), the highly reflationary policies will lead to wage and inflation pressures emerging earlier. The NAIRU is the specific level of unemployment in an economy that doesn’t cause inflation to increase.
Policymakers have made clear their intent to enact policies that would help lower-income households, either via direct fiscal action or indirectly by allowing the economy to run ‘red-hot’.
By the first quarter 2021, GDP levels in the US would have reached 98.7% of pre-covid-19 levels, yet policy support will likely remain very accommodative.
With policymakers maintaining highly reflationary policies to get back to pre-covid-19 rates of unemployment quickly, wage pressures and inflation will pick up from the second half of FY21. Morgan Stanley expects underlying core personal consumption expenditure (PCE) inflation to rise to 2% in the second half and to overshoot from the first half of 2022. This comes with the risk that it happens ahead of schedule.
Several investment managers can see a rationale for investing in emerging markets at present. In a perfect world, as investors we would all like the optimum time to enter the market.
Based on some strategists' warnings of debt contagion and traditional structural issue in emerging markets, an investor may be tempted to apply some caution. However, for many investors, both private and professional, emerging markets are considered a core allocation when seeking seeking long-term growth.
Part II of this article looks at currency and equity opportunities, within separate emerging market countries. The aim with equities is to identify those industries, sectors and companies that should benefit from tailwinds.
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