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.