Optimism Capped by Renewed US-China Tensions in May

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Three Things We’re Thinking About Today

1. The COVID-19 outbreak has heightened global concerns of excessive dependency on China’s manufacturing sector and led governments in many countries to incentivize companies to shift their manufacturing base back home. While we have already seen higher tariffs lead some companies serving the US market to move to other supply centers, we believe that a broad shift out of China is unlikely in the short term due to factors such as its high labor productivity, favorable infrastructure and sophisticated supply chains. Particularly in the case of high-tech products and services, China also offers a huge market for innovative products and has become a strong leader in technological advancement. China’s manufacturing supply chains have, in fact, proven to be highly resilient, demonstrating China’s competitive advantage by getting back up to near full capacity/utilization very quickly following the COVID-19 outbreak. Concurrently, however, we do expect pressure for greater localization to continue given security concerns around health care and technology supplies. The degree to which end customers are willing to pay more for greater security of supply will be a key determining factor.
2. The bone of contention with the US Holding Foreign Companies Accountable Act, which could result in the delisting of Chinese companies from US stock exchanges, is the lack of perceived transparency over audited financial statements. Since Chinese firms are audited locally (in most cases by the “Big Four” multinational accounting firms or their affiliates), China’s policy has been to deny overseas regulators access to the audits, citing national security concerns. This has been a long-running issue between the United States and China, and negotiations have been ongoing for years. The Act states that a company would be delisted if it failed to comply with the Public Company Accounting Oversight Board’s (PCAOB) audits for three consecutive years. If the bill becomes law, we believe that the stipulated three-year transition period would allow for companies to comply and gives ample time to resolve differences and put policies in place that satisfy the PCAOB and China’s regulators. However, companies facing tighter regulatory scrutiny would, in all probability, accelerate the dual-listing trend. We have seen some Chinese companies list on the Hong Kong and Chinese exchanges, and we could see some of the other US-listed Chinese companies also list in the Hong Kong or Chinese exchanges in the future.
3. The gradual re-opening of economies and increased mobility as governments start to ease social distancing measures has raised expectations of a recovery in consumerism. While the economic impact of the virus is expected to weigh on many emerging market (EM) economies in the short term, we believe that the consumer trends we have been witnessing for some time are likely to remain relevant. For example, goods and services related to health and wellness were a fast-growing trend prior to the crisis, and we believe this theme will remain broadly intact post-crisis—perhaps even more so. Additionally, there is strong demand for goods and services such as cars, high-speed broadband, life insurance and home ownership (and therefore, banking products like mortgages) in EMs, where penetration remains low. For example, vehicle sales in China have returned to pre-COVID-19 levels, with April sales increasing to 2.1 million, in line with the 1.9 million in January and a strong rebound from the recent low of 0.3 million in February, as the economy continues to normalize.¹ We do not expect the virus to ultimately change those wants and needs. Middle-class and affluent consumers in Taiwan, China, India, Russia and Brazil, for example, should carry on trading up for higher-quality goods and services, as consumers in developed markets have done. As investors, we feel that those areas represent potential opportunities as we move past the current crisis period.

Outlook  

With the COVID-19 outbreak likely passing its peak in the United States and China (barring a second wave) and governments focusing on returning to normalcy and gradually re-opening their economies, attention has once again returned to the trade conflict between the two nations. Concerns over the origin and spread of the virus have further sharpened the divisions. While there has also been some market concern over the possible collapse of the agreement given the substantial change in economic conditions as a result of the pandemic, we expect both parties to still try to meet the obligations.

It has been about two years since the world’s two largest economies have been embattled in a trade war that has since expanded into conflicts over a range of areas including technology, finance, and most recently, the origin and spread of the COVID-19 pandemic.

Optimism surrounding the “phase one” trade agreement and expectations of continued negotiations between the United States and China was short-lived, as the COVID-19 pandemic took center stage. The economic cost of the pandemic has been substantial, with a marked increase in unemployment and significant worsening of the financial conditions in many countries.

Although governments globally have undertaken unprecedented fiscal and monetary stimulus globally to offset the impact, the exact timing of a recovery is uncertain. For companies, we expect to see downgrades for 2020 earnings across most countries and sectors. EM valuations look even more appealing to us, with the price-to-earnings discount to developed markets widening to 35% as of end-May, from 25% as of end-December 2019. Although we expect to see volatility in earnings forecasts over coming months, we believe that our focus on long-term sustainable earnings power should help us navigate this period.

Emerging Markets Key Trends and Developments

EM equities extended their advance in May but trailed their developed-market counterparts. Investors welcomed a gradual easing of coronavirus-related lockdowns in several parts of the world, encouraging reports on vaccine trials, and more economic stimulus globally. However, renewed US-China trade tensions capped some optimism. EM currencies broadly strengthened against the US dollar. Oil prices recovered on supply cuts and hopes of improved demand as economies restart. The MSCI Emerging Markets Index increased 0.8% in May, while the MSCI World Index returned 4.9%, both in US dollars.²

The Most Important Moves in Emerging Markets in May 2020

Asian equities bore the brunt of growing US-China friction and fell slightly in May. Stocks in China weakened as the country locked horns with the United States on several issues, including the origin of COVID-19 and its move to introduce a national security law for Hong Kong. Taiwanese stocks retreated amid investor outflows. Indian equities declined; disappointing stimulus measures and the authorities’ extension of a loan repayment moratorium added to concerns about the economy and the banking system. In contrast, Thailand’s market rose as the central bank cut interest rates and economic activity gradually resumed. An appreciation in the rupiah bolstered Indonesia’s equity returns. South Korean stocks advanced as policymakers cut the benchmark interest rate to a record low and ramped up financial support for businesses.

Latin American markets were among the top EM performers in May on signs of increased mobility as some governments started to ease restrictions. Argentina, Brazil and Mexico were among the leaders, while equity prices in Chile and Peru declined. A stronger real and continued monetary easing drove sentiment in Brazil; the central bank cut the key interest rate by a larger-than-expected 0.75% to a record low of 3.0%. Strength in Brazil’s currency was supported by reassurance from its central bank president that foreign exchange reserves would be used to defend the real, if needed. Similarly, in Mexico, appreciation in the peso and a 0.50% interest-rate cut shored up equity market returns. In Peru, the central bank maintained its benchmark interest rate at a historic low of 0.25% in May, following a 1.0% cut in April.

Most markets in the Europe, Middle East and Africa region recorded gains with Russia, Poland and Hungary among the region’s leaders. Appreciation in the ruble and higher oil prices drove equity prices in Russia, while slower growth in new COVID-19 cases in the country and easing quarantine measures also provided investors with some good news. Although the South African market recorded a positive return amid a stronger rand and a gradual easing of lockdown measures, the market lagged its regional peers. The South African Reserve Bank cut its benchmark interest rate by 0.5% to a record low of 3.75%, lower borrowing costs for households and corporations. The central bank also relaxed regulatory requirements on banks and took steps to ensure adequate liquidity in domestic markets.

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1. Source: China Association of Automobile Manufacturers.

2. Source: MSCI. The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging-market countries. The MSCI World Index captures large- and mid-cap performance across 23 developed markets. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com.