International | Feb 24 2021
After emerging markets have weathered pandemic storms, equity and currency strategists chart a course for investors in a region considered a core holding by professionals.
-A weaker US dollar and stronger EM currencies
-Taiwan manufacturing and Vietnam supply chains
-The K-New Deal in South Korea
By Mark Woodruff
In Part I of this article, FNArena explored the current investment thesis for emerging markets and what traditionally drives or inhibits their performance. (https://www.fnarena.com/index.php/2021/02/17/the-case-for-emerging-markets-investment-part-i/)
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 link (https://www.fnarena.com/index.php/2021/01/29/are-chinese-shares-a-unique-opportunity-part-i/).
We will begin with expectations for emerging market currencies, after a brief examination of how the pandemic initially roiled markets and the chain of events that allowed the resumption of a semblance of calm.
EM currencies – The turn around
Unless another ‘black swan’ descends on the market, currency strategists at ANZ Bank predict Asian currencies are set to do well in 2021 as the nightmare of 2020 fades.
For the foreign exchange market, the turning point during the pandemic came when the US Federal Reserve provided dollar liquidity via new swap line arrangements with central banks. They also established a new facility for foreign and international monetary authorities (FIMA repo facility) to access US dollars.
The Fed’s actions succeeded in easing strains in the global US dollar funding markets, as central banks were quick to utilise the swap facility. As a result, selling pressure on Asian currencies started to abate.
Although foreign portfolio inflows into the region did not resume until June 2020, the recovery in Asian currencies was afoot as dollar funding concerns eased, helped also by the US dollar coming off its highs.
At the same time as the foreign inflows resumed, China’s lockdown measures had achieved success and its economy had started to rebound. In addition, global economic activity, which plunged to a low point in May, also started to improve in June, contributing to Asian currencies recouping earlier losses.
Before we look at anticipated moves in the various EM currencies, it is timely to re-examine some definitions commonly encountered in research by currency strategists.
Currency Definitions
Chinese money comes by two names the yuan (CNY) and the renminbi (RMB). The distinction is subtle. While the RMB is the official currency of China, where it acts as a medium of exchange, the yuan is the unit of account of the country’s economic and financial system.
Some investment strategists also refer to the CNY NEER. The NEER is the nominal effective exchange rate between a home country (so not peculiar to China) and trading partners, adjusted for the respective weights of those trading partners.
EM currencies
ANZ Bank is bullish on Asian currencies for 2021 and it is not just because of a weaker US dollar, though it helps. There are three key drivers behind the view, in what is seen as a winning trifecta that will see Asian currencies appreciate further this year.
The first is the region’s relative success in virus containment. This means with the global vaccine roll-out can eradicate the virus more quickly, thus allowing a faster normalisation of activity.
The second is the improved global growth prospects this year which bodes well for Asian exports and the broader investor risk sentiment.
Finally, Asia should benefit from increased foreign investor allocation into the region, given ample global liquidity and a better growth outlook.
The ANZ forecast envisions global economic prospects to improve in 2021. Although the US economy will also rebound, there is likely to be a period where the US underperforms on a relative basis.
This has typically been the norm for the past two decades, when the US dollar tended to weaken on a trade-weighted basis, except when there is some sort of crisis which stirs strong safe haven demand for the US dollars. Another traditional cause for US strength has been when US monetary policy is on a normalisation path out of sync with the rest of the world.
In the absence of those factors, the natural state tends to favour a weaker US dollar. Based on the current difference between US and global industrial production growth, ANZ forecasts the dollar has scope to weaken a lot further.
Chinese yuan
How the Chinese yuan fares will be important as it serves as an anchor for the other currencies in the region. The many and varied arguments for a stronger CNY include an improving external balance, strong portfolio inflows on the back of bond index inclusion and wide interest rate differentials.
There’s also the prospect that China’s central bank, the People's Bank of China (PBoC) could be the first central bank to exit unconventional easing.
In a world where global policy rates are at the effective lower bound or record low levels, and set to remain so for some time, being the first central bank to contemplate some form of exit would send a very positive signal for the Chinese currency.
Importantly, ANZ still sees the yuan as undervalued, and the Chinese authorities have been comfortable in allowing the currency to appreciate. It’s considered likely the CNY will strengthen towards US$6.30 by the end of 2021.
At the time of writing, the bank’s forecast appears prescient, as yuan strength versus the US dollar since January 1 has seen the rate move to 6.46 from 6.58.
Morgan Stanley is in agreement on future Chinese currency strength and feels the CNY nominal effective exchange rate (NEER) could break to two-year highs.
Korean won & New Taiwan dollar
The Korean won (KRW) and the New Taiwan dollar (TWD), being two of the major export-dependent economies in the region, are set to gain from the improved external environment.
The extent of appreciation will be capped by the authorities, but they will not be able to hold any particular level for long, in ANZ’s view. There is also a limit to how much intervention can be undertaken before one runs the risk of being labelled a “currency manipulator” by the US Treasury, with economic and political implications.
Morgan Stanley also feels the improving global economic outlook and continued strong demand for technology related products, as seen by the rebound in global semiconductor sales, will benefit the exports of South Korea and Taiwan.
Hence, both the Korean won and New Taiwan dollar will benefit from this cyclical story. However, the bank sees more potential for the KRW to outperform the TWD. For a start, the appreciation in the KRW hitherto has broadly been consistent with the recovery in its exports. In contrast, the TWD’s rally looks to have run ahead of Taiwan’s export growth.
The bank notes there are no signs that TWD strength has severely eroded export competitiveness, and therefore it’s expected the authorities will gradually allow further TWD gains.
EM Equities
Alongside favourable trends in technology and e-commerce, emerging market stocks still offers a good level of exposure to a value recovery in energy, financials, industrials and materials, predicts Wilsons Advisory.
China
As detailed in Part I of this article, China not only dominates the EM market benchmark with a 43% share but also Chinese economic growth spills over into strength for many other EM economies. This, in combination with above-trend growth for the global economy, has can spur EM growth, explains Morgan Stanley.
The US investment bank sees 9% GDP growth in 2021 for China, led by a strong recovery in private consumption and global demand, before moderating towards its potential of 5.4% in 2022. It’s also considered policy will tighten counter-cyclically amid reflation.
Morgan Stanley maintains a balanced growth/value position, but favours selective cyclical exposures. It also sees a transition to late-cycle plays versus early-cycle plays and continues to prefer A-shares over offshore China.
Sectoral recommendations for investors are to stay overweight Internet, Discretionary, Materials and Industrials and stay underweight Energy and Financials. The bank has also downgraded Technology Hardware and Semiconductors to equal-weight, while upgrading Healthcare to overweight.
Regarding Hong Kong, both the Hong Kong and China equity markets are expected to benefit from President Biden’s more moderate stance towards China and successful pandemic management. Given the inexpensive valuation and relative underperformance of the Hong Kong market versus the US market and A-shares, risk appetite should improve next year.
For a more in-depth analysis of Chinese equities and one potential way for investors to access China A shares please refer to (https://www.fnarena.com/index.php/2021/01/29/are-chinese-shares-a-unique-opportunity-part-i/)
Taiwan
Along with China and Vietnam, Taiwan is one of the three Asian economies that maintained positive growth in 2020 despite the covid-19 pandemic. Thanks to the government’s early and effective response to the pandemic as well as the strong performance of its technology sector.
GDP growth is expected by DBS Group to pick up to 4.2% in 2021, from around 2% in 2020, and CPI inflation is forecast to rise to 0.5% from around zero.
The technology sector, semiconductors in particular, will likely remain as the key driver. On one hand, global demand for computers and consumer electronics is expected to decline next year, as the one-off purchases related to remote work and distance learning dissipates. On the other hand, demand for cloud, data centres and 5G will likely continue to increase in 2021, as many countries around the world build digital infrastructures and push for the process of digital transformation after the pandemic.
Smartphone demand is poised to recover in 2021 as global income conditions improve and more consumers move to upgrade amid the expansion of 5G networks. Overall, the outlook for semiconductor demand remains constructive.
DBS Group believes trade disruption risk, as a result of the China-US trade war, may decrease in 2021. Pressure is considered to remain for Taiwanese technology companies to diversify their supply chains to hedge the risk of China-US technology tensions.
Favourable fund flows for 2021 are likely given an improved global environment, record revenues by TSMC, the largest listed company in Taiwan, and broadly positive risk sentiment.
The Taiwanese government’s swift response has succeeded in containing the outbreak without resorting to a nationwide lockdown, thus averting a deep economic contraction, explains ANZ Bank. Taiwan’s economic recovery was also driven by a strong rebound in exports, thanks to the upturn in the global semiconductor cycle.
Also boosting growth is the shift in manufacturing production to Taiwan from China over the past couple of years since the US-China trade conflict broke out.
However, some strategists are wary regarding geopolitical risks. Martin Currie, the active equity specialist, reminds us how exposed Taiwan is to the deterioration in relations between China and the US. Militarily, an invasion is considered not beyond the capabilities of the People’s Liberation Army. Any reaction by the US would almost certainly involve bombing of the mainland. However, the threat of nuclear war is likely holding both sides back.
South Korea
Matthews Asia highlights South Korea by most metrics should be regarded as a developed country. Some leading global index providers like the financial times stock exchange (FTSE) already consider it such.
The country is not seen as a particularly attractive market for domestic consumption growth, though does have some world-class companies.
DBS Group expects the economy to grow by 2.9% in 2021, a moderate rebound compared to the – 1.1% contraction in 2020. Both consumption and exports will likely pick up at a moderate pace.
President Moon’s government should be in a good position to implement the K-New Deal in July of 2021, states DBS Group. This aims to reinvigorate the economy after the pandemic. The government will spend 8% of GDP in the next five years to create jobs in the digital and green energy sectors and to enhance the social safety net.
As part of the K-New Deal, the Digital New Deal involves investment in big data, 5G and AI to build digital education infrastructures, smart hospitals and smart cities. It will also enable smart industrial complexes and smart logistics centres.
A Green New Deal also requires investment in eco-friendly infrastructures and renewable energy. This is aimed at both achieving the 2030 greenhouse gas emission reduction target and the reaching the 20% renewable energy production by 2030.
Despite this potential boost, Oxford Economics prefers to weigh the recent past and considers that even without the adverse impact of the US-China trade war and the covid-19 pandemic, South Korea’s export performance has been sub-par.
The country’s international competitiveness has been restricted by a strengthening currency and rising unit labour costs (ULCs). The appreciation in the ULC-based real effective exchange rate (up around 50% since 2009), demonstrates not only a loss of cost competitiveness due to a broadly stronger currency but also the increase in South Korea’s ULC relative to that of Japan and Taiwan.
The electronics/information and communications technology (ICT) sector has broadly contained the ULC since 2014, despite headwinds from other key industries. This underscores the need for restructuring in struggling sectors, according to Oxford Economics.
The more upbeat Morgan Stanley notes Korea, along with other North Asia peers, outperformed Asia (ex Japan) on growth in 2020. This recovery is expected to continue into 2021, though as others catch up, the growth divergence which had widened in favour of Korea this year will likely narrow in 2021.
One widely held fear is that normalisation in one-off technology demand could take the wind out of the sails of exports. Morgan Stanley thinks that the recovery in the memory space since the second half 2020 would likely offset any one-off technology demand normalisation elsewhere, and take Korea’s exports growth higher.
Meanwhile, ANZ strategists feel South Korea is well positioned to benefit from the cyclical recovery in the global economy. Reflective of this optimism is a strong recent rebound in foreign buying of Korean equities. In fact, November 2020 saw the highest monthly inflow in more than seven years.
Latin America
The Oxford Economics in-house measure of economic recoveries continues to show a slow and steady recovery in the Latin American region. As of early December 2020, Chile and Colombia had closed the gap with leader Brazil, while Mexico’s recovery had stalled.
The research house is not too worried about a recent surge in inflation. So far it is too localised in food prices, and core inflation remains low throughout the region.
The return of the left to Bolivia, impeachment of Peru’s president and a new constitution in Chile are all considered sources of downside risks to the recovery in 2021.
Brazilian companies, according to Matthews Asia, are on the leading edge in several fields such as fintech and digital payments. On balance though, Brazil is considered to have a smaller number of innovative companies than China does for example, and it is not an emerging presence in potentially large segments such as biotechnology.
The high cost of capital in Brazil has been detrimental to innovation and local entrepreneurship, although it means those who have achieved scale tend to be of a very high quality.
The global emerging markets manager believes the recovery will continue on the back of strong global growth and domestic demand helped by a low interest rate environment. Some limited fiscal slippage will keep uncertainty high though this will be gradually lessened with progress on the reform agenda.
A still wide negative output gap should keep core inflation in check and help the central bank to keep rates low and only start normalising monetary policy in the fourth quarter 2021.
India
DBS Group forecasts the Indian economy will gain strength in 2021 and Morgan Stanley also maintain a constructive view on the economy. The latter expects the growth recovery to gain strength from the second quarter of 2021. Despite inflation remaining marginally above the 4% target, policy rates will only see a first lift-off at year-end as a result of an extraordinarily accommodative stance.
The government has implemented structural reforms in the manufacturing and agriculture sectors, which should help to lift medium-term growth prospects.
Additionally, government efforts to undertake privatisation have the potential to help improve the health of public finances.
Vietnam
DBS Group notes Vietnam has been a shining example in the region in terms of its ability to contain the spread of the pandemic. It has returned the least number of cases across broader Asia, together with preventing fatalities. This can be attributed to early detection and decisive actions taken by the state. These include being the first to close its land borders with China and imposing strict lockdown on towns at the early onset of the pandemic.
Export growth will likely be strong in 2021, particularly given the economic turnaround in some of the key regional markets such as China. DBS Group expects the manufacturing sector to be a key driver of growth, bolstered by gradual improvement in domestic services and construction activities.
Private consumption and investment growth could provide added impetus to growth beyond the expected boost from the recovery in external demand and trade flows. This should lift GDP growth to 6.7% in 2021, though with more pronounced improvement from the second quarter onwards.
DBS Group believes the external environment could remain conducive, with the new US administration providing more certainty around trade. The trade surplus with the US is expected continue growing amid the diversification of trade and investment flows from China to ASEAN. Vietnam will remain a key beneficiary in the reshuffling of regional supply chains in the coming years.
Russia
Morgan Stanley sees 16% upside in US dollar terms over the next 12 months (NTM) for Russian equities.
Current NTM dividend yields for the overall market are very attractive, especially when compared to other markets and a similar level of European major oil companies.
It’s expected dividends will recover in 2021 and 2022 after a decline of 34% in 2020. The forecast is for an increase of 26% in 2021 and another 26% in 2022 (versus 32% and 25%) respectively from consensus.
Morgan Stanley doesn’t anticipate material Russian sanctions by the US post elections.
While headwinds are likely to keep a cap on oil prices near term, the bank’s global oil strategist has $50/bbl Brent forecasts for the second half and $60/bbl forecast in a bull case scenario. The key longer-term risk to the Russia overweight call remains rising investor ESG focus, the high share of fossil fuels in the MSCI Russia index and the added risk of the country's permafrost thaw.
Russia has 24 regions that are permanently frozen and nine of those contain extensive infrastructure and cities. These regions are key to Russia’s economy producing the bulk of its raw materials that account for almost half of the country’s GDP.
South Africa
The Morgan Stanley South Africa strategist sees 15% upside potential in US dollar terms to MSCI South Africa in the next 12 months.
Diversified miners are still considered relatively cheap, but with risk of significant earnings upgrades if spot commodity prices hold. Top picks in the sector are Anglo American and African Rainbow Minerals.
Regarding technology, the bank is concerned that potential de-rating of the Chinese technology sector (in the face of a successful vaccine and uncertainty around the anti-trust legislation) could weigh on South African big caps.
However, the prospects of a buy-back for consumer internet company Naspers should mean a sufficient cushion to offset the de-rating risk. On a longer-term view the growth and valuation combination on offer from Naspers is one of the most attractive across the Johannesburg stock exchange.
Historically a defensive sector, healthcare has performed like a cyclical as covid-19 led to surgery cancellations and weak hospital volumes. Oxford Economics expects a strong earnings recovery for the hospital stocks as the pandemic shock normalises over the course of 2021. Life Healthcare is considered the top pick in this space.
Banks are arguably the easiest (i.e. most liquid) way to play a domestic re-rating story driven by the strong trade balance and government progress on reforms (such as the corruption crack down). Firstrand and Standard Bank are the preferred picks.
Finally, Bidvest is the top pick in this the industrials sector. Morgan Stanley sees the stock as well positioned for a cyclical recovery in South Africa through its consumer products and business services offerings.
Conclusion
For many investors, both private and professional, emerging markets are considered a core allocation when seeking long-term growth.
Many investment managers are bullish on growth prospects for emerging market equities and forecast strength for emerging market currencies, while others currently have specific reservations.
For such a diverse geographic region caution should be exercised as the pandemic has fallen unevenly across different countries, industries and sectors.
In many instances investors lack either the time or resources to focus on individual stocks and elect to invest via professionally managed exchange traded funds.
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