Emerging Markets: The case for moving overweight
Chris Watling, Longview Economics
“It’s taken just a few short months for stagflation to go from hobgoblin of cranks to a full-blown Wall Street obsession.”
Source: Bloomberg article “Stagflation Is All Anyone in Markets Wants to Talk About Now”, 12th October 2021
The drumbeat of bearishness towards emerging markets has grown louder this year. That’s been driven by multiple factors, including (i) rising Chinese-related risks (e.g. real estate sector stress, regulatory challenges and so on); (ii) the slow vaccine roll out in EMs; (iii) growing concerns about the efficacy of EM/Chinese vaccines; (iv) US dollar strength; and, more recently, (v) growing fears of poor global growth (coupled with high inflation), see quote above.
Reflecting all of that, positioning in EM assets has reversed significantly: At the start of the year, EM assets were a popular and crowded LONG trade. Today, sentiment is facing the other way, with ‘short China’ ranked as one of the top most crowded trades amongst investors*.
The key question therefore is: Are the bears correct? Will EM assets continue to underperform DM for the next 6 - 12 months? Or, is all the bad news in the price, with consensus thinking, once again, wrong (and generating a contrarian buy signal for EM assets)? And what about longer time frames? Having traded sideways for the past 13 years, many now view EM equities as an investors’ graveyard (as the cartoon illustrates). Are EM equities therefore in the midst of a long term downtrend? e.g. like Japanese equities from 1989 to 2009. And, if not, is there a long term case for owning EM equities and other EM assets?
*According to the September ’21 BAML fund manager survey.
In our view, there are four key reasons to expect EM equities to trend higher, and outperform developed market equities over the next 1 – 2 years, and probably beyond.
1. The global economy is poised to rapidly reaccelerate, despite heightened concerns about stagflation (see above). Environments of robust global economic growth are typically associated with strong EM asset price returns.
In particular, the US economy should be a key source of fuel for a global reacceleration, especially as the COVID-19 pandemic becomes endemic (and supply chain tensions ease, see below for detail). Of note in that respect, the structural and cyclical health of the US corporate sector is strong. Companies are running a large surplus cashflow position (of 1.7% of GDP); their levels of cash have grown significantly in the pandemic; and business confidence is at a record high. Companies are therefore likely to start putting their spare cash to work, by rebuilding inventories (from low levels), creating jobs, and increasing capex. At the same time, the household sector is also in strong health (‘spare’ cash levels are large, wealth effects from housing are strong, and the capacity/appetite to re-leverage is high). As such, as pandemic-related issues fade, and pent up demand is released, the US trade deficit should grow, resulting in stronger global economic and trade growth.
Fig 1: Total global trade (USD) vs. Southeast Asian Equities (MSCI index)
Of interest in that respect, global trade has been broadly unchanged in recent years (i.e. from 2013 to 2019). Post the pandemic, though, world trade has risen to new highs on the back of significant global stimulus and a rapid growth recovery.
Given the cyclical and structural strength of the world’s largest economy, and the likelihood therefore of a wider US trade deficit, global trade should remain strong and continue to trend higher. As fig 1 shows, an uptrend in global trade typically results in a cyclical equity bull market in key emerging market equities (particularly those with open economies and large export shares of GDP, including Southeast Asian exporters**).
2. Linked to point 1, the primary trend in the US dollar is down. Multi-year downtrends in the US dollar drive secular bull markets in EM equities (and vice versa), both in absolute terms, and relative to DM equities, e.g. see fig 3.
In the short term, various factors influence the direction of the dollar (including interest rate differentials, fear & greed, safe haven buying, and so on). In the longer term, though, the structural trend in the dollar is principally driven by US dollar capital flows which, in turn, are strongly influenced by changes in the US fiscal and trade balance (see fig 2).
Fig 2: US twin deficits (as % of GDP, advanced 2 yrs) vs. broad dollar index
**Most notably Malaysia, Indonesia, Thailand, and the Philippines.
In particular, a deteriorating ‘twin deficit’ in the US results in phases of sustained US dollar weakness (and vice versa). That’s illustrated in the chart above, in which the US ‘twin deficit’ has been pushed forward by two years. In other words, the combined fiscal and trade balance is typically a leading indicator of the trend in the dollar.
As highlighted in point 1, a wider US trade deficit is likely in coming years. In addition, and while the US fiscal deficit is expected to narrow in 2022, that’s likely to be followed by a significant and sustained widening (i.e. according to latest CBO forecasts).
Fig 3: US dollar (DXY) vs. DM equities relative to EM (shown with US recession bands)
3. EM vaccination rates are rapidly catching up with the west and, despite fears about vaccine efficacy in EM countries, EM infection and death rates are trending down. Of note, Asian and South American countries have widely adopted Chinese vaccines, which have lower efficacy compared to the US/UK alternatives. Despite that, infection and death rates in those countries are (i) trending down; and (ii) are currently lower than in North America and Europe. In other words, the reduced efficacy of Chinese vaccines does not appear to be material (especially in the broader context of the various factors which impact infections and deaths, including vaccine hesitancy; lockdown policies; seasonal factors; the average age and underlying health of the population; and so on).
In other words, while vaccine roll out in EM economies has been delayed, it’s not flawed, as some have suspected. The pandemic is therefore increasingly becoming endemic in emerging markets, and globally (47% of people in the world have now had at least one vaccine dose, while 35% are fully vaccinated, i.e. with two doses). That shift, from pandemic to endemic, is likely to be the catalyst for the easing of current supply chain challenges, and therefore stronger production and trade activity. Given that most of the world’s goods are produced in emerging market economies, the fading of the pandemic should significantly boost economic and earnings growth in EM countries.
4. EM equities are cheap both relative to DM equities, and on a standalone basis. Compared to both the US and global equity market, for example, EM equities are at their cheapest since 2004 (e.g. see fig 4 below). On standalone forward PER, EM equities are trading at 13.2x forward earnings (and in line with their long term average valuation, i.e. since 1990). All of that paints a bullish long term outlook for EM equities. In particular, and while valuation is not a helpful timing tool***, the factors we describe above (points 1 – 3), suggest that both (i) an EM equity market re-rating; and (ii) a phase of robust EM earnings growth are now likely.
Fig 4: MSCI forward Emerging Market PER relative to forward S&P500 PER
***In 2014, for example, EM equities were at their cheapest valuation in 10 years relative to the US (and at similar levels to today). Despite that, EM equities have since broadly traded sideways (in USD terms) and have underperformed DM equities.
Risks: There are multiple risks to our bullish view on EM assets. In particular, it’s possible that China (still) faces its own ‘Lehman moment’, despite some modest policy easing measures by the authorities in recent weeks. Of note in that respect, many of the major imbalances in the global economy today are in China (similar to the build-up of economic excess in the US economy ahead of the 2008 banking crisis). Whether the fallout from Evergrande spreads across the real estate sector, the banking system, and other parts of the Chinese and global economy therefore bears watching closely.
In our view, though, the China situation is likely to be contained by policy makers, who have, in recent years, followed a ‘squeezing & easing’ approach to de-risk their economy. That is, they use policy to ‘squeeze’ the froth from sectors where the excesses are the largest (i.e. banking and housing). That’s then followed by ‘easing’ and targeted support measures to mitigate the fallout and contain the stress. In other words, the authorities conduct a series of ‘controlled explosions’ as they attempt to reduce leverage and de-risk the economy. Mostly this has been done in the banking system, where the authorities eventually intervene to prevent a systemic shocks (i.e. by bailing out various banks, e.g. Baoshang Bank in 2019). Ultimately, therefore, a policy response to the Evergrande situation is likely.
The other key China-related risk to EM assets is the current/ongoing slowdown in the Chinese economy, as a result of weak credit growth and a lack of monetary stimulus/support from the PBoC. In that respect, a number of leading indicators suggest credit growth should slow further. As the chart below shows, though, phases of weak Chinese credit growth usually trigger a cycle of RRR cuts by the PBoC (i.e. as they respond to slower economic/credit growth). Looser policy in China is therefore likely in coming months and quarters and should help reflate the Chinese (and other EM) economies.
Fig 5: Total Social Financing (12m smoothed) vs. PBoC RRR for large banks
Interested in emerging markets? Visit the newly launched website of our affiliate Ox Capital Management for further insights on the investment opportunity in EM.