Emerging markets diverge as Covid leaves its mark

It is often tempting to lump emerging market economies into one huge bloc, despite the obvious differences between markets. But the coronavirus pandemic has illustrated how these economies perform very differently to one another.

Emerging Asian equities outshone the broader asset class in the third quarter, with investors heading for local technology companies, while Latin America struggled and European markets also underperformed. 

While it is too early to assess the full damage of Covid-19, and the longer-term changes it will trigger in global supply chains and demand for emerging markets export, it is clear that some economies have made it to the other side while others face an uphill task, says Kunjal Gala, global emerging markets co-portfolio manager, international at Federated Hermes.

“Markets which were ‘first-in’ and ‘first-out’ have led the rebound in emerging markets and those still struggling with the first-round effects have performed the worst,” he explains, “ which has resulted in a two-speed recovery.” 

In China, Korea and Taiwan,  which makes up 65 per cent of the EM investment universe and index, the virus situation has been controlled and economic activity is back to 85-90 per cent of pre-Covid levels with stockmarkets for all three moving into positive territory.

In particular, China’s recovery has been faster than expected.

“Markets are inextricably linked and China’s V-shaped recovery to pre-Covid levels is an important driver of recovery in demand supporting export markets like Korea and Taiwan; but, beyond that, the ripple effect of Beijing’s focused FAI [fixed-asset investment] stimulus is supporting the commodity-sensitive markets of Emea and Latin America,” he explains.

Despite the damage done by the pandemic, the emerging market structural growth story remains intact, believes Mr Gala, driven by an aspiring, growing middle class, rising digitalisation, reforms and infrastructure development. “As industries consolidate, companies with strong balance sheets and capabilities will benefit from these structural drivers,” he adds, pointing to the long-term structural themes of 5G, digitalisation, the internet of things, rising financial penetration, healthcare, premiumisation and infrastructure. 

“Overall, we view the current environment not as a threat, but as an opportunity to increase our exposure to excellent-quality companies that are now available at discounted prices and we are selectively adding a few value names where we feel that the companies are trading substantially below their intrinsic values,” says Mr Gala.

Spreading the growth

In some respects, a healthier Chinese economy is clearly positive for emerging markets, says Alex Wolf, head of investment strategy for Asia at JP Morgan Private Bank, but it depends on the composition of that growth. China has rebounded very quickly, predominantly due to strong exports, as their factories were open when many across the globe were not, while the country is the world’s largest producer of both personal protective equipment and electronic devices — both of which have been in high demand during this period. 

“This means their growth is currently less complementary to other emerging markets than in the past,” he explains. China generally boosts other emerging markets through commodity imports — in the past when construction was booming, oil, iron ore, and copper imports would lift commodity producers. 

“However at the moment it’s less of a boost and, going forward as China transitions away from investment towards domestic household consumption, it’ll be less of a positive impulse for the rest of emerging markets,” adds Mr Wolf. 

The pandemic has shown investors the importance of being selective when it comes to emerging markets, he believes. 

“This year, more than almost any in recent history, showed the benefit of treating emerging markets on an individual basis and not as a homogenous bloc. The divergences across emerging markets and even within regions — Asia for example — have been huge, so it’s important to invest in countries with strong growth fundamentals and attractive valuations, but not necessarily emerging markets as an
all-or-nothing investment.”

This has been a difficult year for emerging market equity performance, but, broadly speaking, the investment case for emerging market equities is improving, says Jeffrey Sacks, Emea Investment Strategist at Citi Private Bank. He points to these countries’ management of the pandemic, a sharp pick-up in growth led by Asia, a weaker dollar, firmer commodity prices than at the start of the year and valuations that are by no means stretched. “That mix of factors gives us confidence looking forward into 2021. We think performance will start later this year, but the next year will be the bigger year,” he explains.

Latin America presents an interesting short-term trading opportunity, says Mr Sacks, as it is currently oversold, underheld and undervalued. 

“At the moment, it is in the midst of the most intense phase of the pandemic and we think it has a recovery rally that has further to go. But no more than that, we are more cautious about the long-term prospects for large parts of Latam. It is a trading rally for short-term funds and those who can be more nimble.”

Ceemea [Central and Eastern Europe, the Middle East and Africa] sees quite specific problems in each of its key markets -— Russia, South Africa and Turkey — he says. South Africa has a challenging economic backdrop, political issues and Covid has hurt them more than most. Russia is held back by ongoing political concerns and while the oil price has bounced, it has not been all that strong; the economy has not diversified sufficiently to provide investors with a broad spectrum of opportunities. Turkey faces enormous economic challenges with its current account deficit and significant debt problems.“So in Ceemea it is too early to bottom-fish. We need to see these problems at least start to get resolved,” believes Mr Sacks.

That leaves Asia as the preferred market for Citi. “We liked it so much at the start of the year that we included Asia as one of our unstoppable trends. Not so much an allocation — it is bigger than that. The long-term drivers for Asia are particularly strong. We are talking about the rising middle class, the increasing policy orthodoxy, and increasing improvement in transparency at a company level,” he says.

Covid has delayed that story, but not stopped it, says Mr Sacks, and Asia has done a far better job at how it has managed to get through the worst of the pandemic than other parts of the world. “What we are starting to see now in Asia is not only a manufacturing pick-up that started in the early part of the summer, but now also a domestic pick-up. That is giving us even greater confidence of a decent end to the year and a strong 2021.”

Trade wars

Donald Trump’s presidency has been marked by a ratcheting up of tensions with China, with increasing tariffs and threats of a damaging trade war. Yet even if Joe Biden wins the election, Mr Sacks expects the US–China relationship to remain unchanged. 

Recent months have seen bipartisan support in the US for confronting China on issues like trade, market access and protection of intellectual property, and those things will not change no matter who occupies the White House, he says. But what might is the tone of the discussions. 

“The level of diplomacy will be calmer, although the direction will similar. But if Biden wins then the US–EU relationship will improve, so you have the potential for a more multilateral approach from the West towards China.”

The China–US relationship is not just a political one, points out Willem Sels, chief market strategist at HSBC Private Banking; rather, companies make decisions too. 

“It is, to a large extent, the companies that decide where to have their production facilities and so on, so investors can manage the situation by focusing on those companies which have exposure to China’s domestic market.” 

He sees plenty of potential in Chinese tech companies, despite the headlines generated by the likes of Huawei. 

“When you actually drill down to the percentage of profits the Chinese tech companies make outside of China, or that they make in the US, it is quite often extremely limited,” says Mr Sels. “In fact they are a way of diversifying away from the big US tech names, where there is a lot of headline risk, be it regulation, taxes or the outcome of the election. In China, a lot of the tech names are either targeting the local domestic consumer, or it is really benefiting from infrastructure spending from the government.”

When there is a lot of uncertainty in the world, as is certainly the case at the moment, a prudent investor heads for quality, he says. That means both quality stocks, with strong balance sheets, and quality countries, those with strong fundamentals and flexibility in terms of fiscal policy and monetary policy.

“The countries with policy flexibility are Russia, China and Korea. Russia still has a lot of headline risk and is very cyclical, and is very related to the oil price, so we are neutral there despite the policy flexibility. The policy flexibility in China and Korea leads us to an overweight position in these two countries.”

Innovation and technology have been the driving forces behind the recovery in emerging markets from the Covid-19 fallout, says Chetan Sehgal, lead portfolio manager at Templeton Emerging Markets Investment Trust.

“We continue to have a high conviction for innovative technology companies within our portfolio. Lockdown measures and social distancing have enforced the growth of effective digital communication, speedier food deliveries, enhanced online learning platforms, better entertainment streaming and online shopping,” he says.

Outside of technology, Mr Sehgal is optimistic about the long-term outlook for consumption growth, particularly in the trend of “premiumisation”, where consumers in emerging markets are keen to upgrade the quality of goods and services they consume as their wealth rises.

As has been the case with global markets, investors who have missed out on tech and growth stocks over the past year have faced an “uphill battle” in emerging markets, says Ian Beattie, portfolio manager of the Nedgroup Investments Global Emerging Markets fund and co-CIO of NS Partners.

He asks if it is time to start talking about the “Pacific Century”, since the best returns from developed and emerging markets are from Chinese and US tech, and most of these names are headquartered on the west coast of the US and part of the east coast of China. “If the 19th and 20th centuries were about the Atlantic, with London and New York, then maybe the 21st is about the Pacific with Hangzhou and the Silicon Valley.”

While the fundamentals of the component countries are important, emerging markets as an asset class is driven by global economic momentum and liquidity. Global money growth has surged to its highest level since the 1970s, says Mr Beattie, signalling both strong economic prospects for 2021 and “excess” liquidity, some of which is likely to flow back into emerging markets. Stronger growth would suggests broader upward pressure on commodity prices, while the Fed’s commitment to an inflation overshoot reduces the risk of renewed US dollar strength. 

“Our emerging market checklist of these and other factors is giving the most positive message since 2016,” he adds. “The suggested scenario would probably be associated with a recovery in performance of cyclical markets, such as Brazil, Russia and Indonesia, with this year’s safe havens — including China — lagging.”

Although emerging market equities have delivered a similar return to developed markets over the very long run, there have been sustained periods of out- and underperformance. 

“We would suggest that a core position should be small but investors should be prepared to move significantly away from it when a large emerging/developed market divergence is coupled with an opposite shift in macro checklist factors — as may be occurring currently,” says Mr Beattie. 

VIEW FROM MORNINGSTAR: China’s rebound leaves clear leader

Emerging markets slightly underperformed developed markets in 2020. For the year-to-date to September 30, the MSCI EM index has returned 1.3 per cent in GBP terms, while the MSCI World index for developed country stocks has returned 3.9 per cent. 

That said, similar to most global markets, there has been wide divergence in terms of investment styles. The emerging markets growth stocks, represented by the MSCI EM Growth index, returned 15.2 per cent year-to-date compared to a loss of 12.1 per cent for the emerging markets value stocks, represented by the MSCI EM Value index. 

Performance has been driven by a handful of momentum growth stocks, namely Alibaba, Tencent and TSMC, each returning more than 40 per cent over this period. The fact that these stocks collectively make up 20 per cent of the MSCI EM index has exacerbated their effect on the market. 

At the country level, China, which led the initial sell off, has been a clear winner compared to other emerging markets, with the MSCI China index returning 19.3 per cent. Chinese equities outperformance has been driven by the country’s ability to control the coronavirus spread much better than some other economies, which has enabled an early economic rebound, while its status as a non-oil-exporting nation has helped as well. 

Among the worst-hit emerging markets has been Brazil, with the MSCI Brazil index losing almost 40 per cent. The driver of market weakness has been macroeconomic vulnerability, exacerbated by the impact of Covid-19.

As expected, the growth-oriented emerging markets strategies have outperformed the value-leaning ones. JPM Emerging Markets has been a standout performer. The strategy is led by Leon Eidelman with the quality growth approach, seeking to invest in companies that boast quality franchises, consistent earnings streams and solid returns on equity. Following strong relative performance and steady inflows, the strategy
soft-closed in May 2020. 

Another leader has been Fidelity Emerging Markets. The strategy benefits from a seasoned lead manager Nick Price, who has successfully managed this strategy since 2009, and is meant to provide exposure to Fidelity’s best emerging markets equity ideas. The manager primarily looks for quality growth firms that exhibit strong and sustainable returns on equity, good balance sheets and shareholder-friendly management teams. 

Conversely, Comgest Growth Emerging Markets has struggled year-to-date. While the strategy also favours quality growth stocks, it is rather price-conscious and as such has avoided Chinese internet giants Alibaba and Tencent, which has hurt its relative performance. In addition, the portfolio has also remained invested in companies that can benefit from long-term domestic growth despite strong macroeconomic headwinds, for example in Brazil and South Africa. 

Lena Tsymbaluk, senior analyst, manager research, Morningstar