Progress Amid Disruption
We are entering the final stretch of what has been an extraordinary year. The COVID-19 crisis has catalyzed the acceleration of some long-term themes that we have identified and followed in recent years. This trajectory will likely continue into 2021. A further marked trend this year has been increased differentiation within emerging markets (EMs) amid rapid changes brought about by various economic, social and exogenous shocks such as the pandemic. We believe the constant flux in EMs underlines the importance of a bottom-up, stock-driven investment approach that is sector- and country-agnostic.
The pandemic has reinforced three key realities in EMs that we have been focusing on. Firstly, the increased institutional resilience in these countries. Secondly, the growth of consumption and technology, resulting in more diversified economies. Thirdly, the growing innovation in EMs—and the capacity of companies to “leapfrog” developed-world competitors. On top of these multiyear themes, three nearer-term issues have our attention: the US-China relationship and deepening bilateral tensions; the impact of COVID-19 on companies and markets; and companies’ readiness to embrace the new normal.
A Broadening Recovery?
Looking back, EM equities have as a whole been resilient, with the MSCI Emerging Markets Index marginally positive year to date—performing broadly in line with the S&P 500 and MSCI World indexes. This does, however, mask wide divergence across countries and sectors. As a region, emerging Asia has outperformed global developed and EM indexes, buoyed by China, South Korea and Taiwan. By contrast, EMs such as Brazil and Russia have lagged, while in developed markets, performance has been concentrated in US mega-capitalization technology stocks, with Europe and the United Kingdom underperforming sharply.
Similar divergence is seen at a sectoral level. While EM equities’ overall valuations have increased, this is largely due to the narrow leadership of internet, technology, consumer and other “new economy” companies that are thriving amid COVID-19. For the MSCI Emerging Markets Index, valuation spreads between the top quartile and median performer are significantly in excess of what has been seen in the last decade, whether measured by price-to-earnings or price-to-book ratios. Similarly, in terms of performance, the top quartile stocks have delivered a 60% return year to date versus the median of -4%, which represents by a considerable margin the widest gap over a 10-year period.1
Unlike many Western countries, much of emerging Asia has thus far successfully managed the pandemic, with the result that business visibility is improving even in “old economy” sectors with relatively attractive valuations. This has the potential to broaden the current equity market rally in the fourth quarter of this year and in 2021. In China, for example, cement producers appear on track for new peaks in profitability, as reviving construction activity post lockdowns and heavy floods drives up demand. In countries that have underperformed, we see further potential. Indian financials, which have slipped amid near-term asset quality concerns, continue to be well-positioned for longer-term growth in an underbanked market, particularly in the vast rural segments. Brazilian financials also appear attractive, while the economy’s reopening could bode well for late recovery plays such as mall operators and education providers.
Past the Trough
On the economic front, EM activity has continued to rebound, albeit at varying speeds across countries. In China, stronger exports and production growth have confirmed a V-shaped economic recovery. Though consumption has been a weak spot, green shoots are appearing, with data on luxury spending and domestic air travel remarkably up year-on-year.
Conditions in India have been mixed. Various states are keen to get economic activity back on track following a nationwide lockdown and most coronavirus-related restrictions have eased. High-frequency indicators such as fuel consumption, travel and credit-card usage have improved to approach pre-pandemic levels. However, areas such as credit growth have been sluggish, with banks remaining wary of a spike in delinquencies amid an economic slowdown. Daily reported COVID-19 cases and fatalities have continued to grow, though the numbers appear to be plateauing.
Brazil’s economy has shown a post-lockdown bounce. Government spending has been critical in backstopping the economy, and better-than-expected data have triggered upgrades in full-year economic forecasts. After a long struggle with the pandemic, Brazil has started to see the number of new COVID-19 cases decline. Paradoxically, the lack of a strict quarantine to contain the virus initially now makes the probability of another wave of outbreak remote, in our view.
Meanwhile, EMs have shown a continued appetite for structural reforms that could lay the foundation for lasting economic recoveries. China, for example, has stayed true to its longer-term goal of making domestic consumption a major economic engine—and a source of potential ballast during external demand shocks. The government’s recent moves to boost local luxury consumption tie in with this ambition. Until COVID-19 hobbled international travel, Chinese spending on luxury goods had largely occurred overseas. Eyeing this purchasing power, officials relaxed duty-free shopping rules, igniting a surge in duty-free sales in China. We see China’s domestic travel and duty-free industries heading for a boom in the next few years.
India’s sizable fiscal deficit has limited the government’s ability to spend on shoring up its economy. We expect privatizations and other economic reforms to offer more support by attracting investments. The country’s “Make in India” initiative, aimed at growing the manufacturing sector, appears well placed to benefit from several trends. Global trade tensions and the pandemic have driven countries and companies toward new production locations to enhance supply chain diversity and security. India’s border skirmishes with China have also sparked nationalistic support for local manufacturing.
Brazil has continued to pursue structural reforms despite economic disruptions and political noise. Officials recently passed new rules for the natural gas and sanitation industries in a bid to unlock hefty investments in the coming years. Discussions on tax and administrative reform proposals are underway. The government’s pipeline of infrastructure concessions also remains robust.
EM corporate resilience—especially in industries bolstered by the pandemic—is likely to anchor market sentiment. In China, we have seen companies across the internet, health care, new energy and consumer sectors deliver stronger financial results. Larger corporates have won market share from weaker players in a challenging environment, illustrating their scale advantage. We believe wider technology adoption, increased innovation, accelerated industry consolidation and other pandemic-induced trends could continue to offer growth opportunities for a wide range of companies.
Corporates in India have also shown several bright spots. Technology services providers have regained investors’ attention, helped by improved client traction and greater cost savings driven by a shift toward remote working. Large banks are also likely to see some recovery and benefit when India’s economy begins to normalize, and the corporate sector starts to re-leverage.
In Brazil, monetary easing and record-low interest rates have been a tailwind for capital market-driven companies. Investors seeking better returns have shifted from fixed income to riskier assets such as equities, boosting trading volumes for brokerages and the stock exchange. Agile e-commerce businesses have also outperformed the market during the pandemic. Meanwhile, we view infrastructure and commodity-related companies as potential beneficiaries of improving economic activity, as well as infrastructure concessions in Brazil.
Opportunities versus Uncertainties
Our constructive near-term outlook recognizes the potential for bouts of market volatility ahead. Concerns could arise as certain EMs approach policy stimulus limits imposed by prudence or shrinking public coffers. In Brazil, massive spending has undercut the government’s debt stabilization efforts and fueled fiscal worries. The country’s gross debt-to-gross domestic product ratio has risen toward 100%, alongside growing doubts about its commitment to a 20-year public spending cap.
The US-China dispute—which could worsen amid political posturing ahead of the US presidential election—is another potential source of market risk. We have seen hostility toward China grow across the US political spectrum and we expect bilateral tensions to remain regardless of the election’s outcome.
As long as COVID-19 remains a preoccupation for investors globally, countries and companies that have effectively managed the crisis and seen their businesses deliver are likely to continue doing well. In addition, growing business visibility and recovery in parts of the old economy, coupled with a wide valuation discount, should lead to a broadening of market performance through the end of 2020 and into 2021.
What Are the Risks?
All investments involve risks, including possible loss of principal. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments.
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1. The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging-market countries. 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.