Investment Adventures in Emerging Markets

Perspective

Asian Equities Drove Emerging Markets Higher in January

Emerging market equities started off the year strong, with positive performances overall in January. Our Emerging Market Equity team provides an overview of what drove market moves, and why it has an eye on frontier markets in particular when looking longer term.

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Three Things We’re Thinking About Today

  1. Emerging markets (EMs) outpaced developed markets in 2020, with the gap widening further in January, reversing a period of underperformance and fund outflows. This is reflective of the fact that many companies, particularly those in East Asia, successfully managed their business operations during the pandemic and should emerge from the crisis in a stronger competitive position. Nonetheless, EM equities continue to trade at a discount to developed markets. An improvement in earnings visibility as economic recovery becomes more widespread across EMs should enable a further broadening of market performance. Corporate earnings are also expected to see a sharp rebound in 2021 from the low base in 2020. Moreover, as we move toward economic normalization, we expect a continuation in the pivot toward value stocks that lagged in 2020. This would especially be the case for sectors such as financials, which were impacted by asset quality and non-performing loan concerns. In general, we believe a faster economic recovery in major EMs, solid fundamentals and undemanding valuations point toward an expectation of outperformance in 2021.
  2. In many EMs, a central new reality is the rise of domestic demand as a driver of growth. By contrast, Taiwan’s companies derive over 70% of revenues from abroad. However, these exports are not low-quality products, nor are they commodities subject to cyclical fluctuations in demand and pricing, characteristics many have historically associated with EMs. Taiwan’s highly educated workforce has been the backbone of its steady ascent up the value chain in manufacturing; it is now an exporter of technology components and essential semiconductor chips that constitute the computing power behind modern technologies. The importance of these products in the world economy is only increasing, which is a powerful tailwind for Taiwan’s economy. In our view, Taiwan is illustrative of the broader transformation of EMs in the last decade toward a higher-quality asset class, with more sustainable sources of earnings growth. The pandemic has accelerated some long-term themes that have benefited Taiwan, which we expect to continue.
  3. Often overlooked, we believe that the frontier markets (FMs) asset class continues to exhibit significant long-term growth potential. The structural opportunity is akin to EMs 30 years ago, except that the development curve is likely to be more rapid due to technology availability. For investors, FMs offer regional diversity across the Latin American, Middle Eastern, African, Asian and Eastern European regions. We have seen frontier economies push idiosyncratic reforms to support macro development. Over the long term, we believe domestic dynamics that are geared toward favorable demographics and under-penetrated sector stories will drive FMs. In contrast to developed markets, most FMs have high population growth rates and an expanding working population. In addition, the pace of urbanization in FMs, when coupled with lower penetration of basic services, creates potential opportunities to tap into a growing domestic consumer market. Rising sovereign debt levels and higher unemployment, however, are among the key challenges that policymakers in FMs would have to monitor and address, in our view.

Outlook

A key contributor to EMs’ performance in 2020 was its exposure to the fast-growing technology sector. EMs broadly have evolved away from commodities and are now heavily weighted in technology, giving exposure to leading-edge innovation which is, in turn, reshaping the industrial landscape across EMs. Digital disruption is one trend in particular that we have been monitoring closely, as this helps us uncover businesses with distinct competitive advantages in technology and innovation.

We continue to witness greater proliferation of online consumers, devices and enterprises, for example. Cloud computing and data centers, Internet-of-Things, high performance computing, artificial intelligence, upgrades to 5G (fifth generation wireless technology) and beyond are expected to continue to drive demand in processors and memory solutions. We are of the view that companies with high sustainable earnings power could continue to perform well in 2021, despite the likelihood that the growth rates of internet-based companies may slow slightly following the COVID-19-related acceleration.

We also seek to capture the long-term structural tailwind of the EM consumer through growing consumption penetration and premiumization of buying patterns. The Chinese consumer opportunity, for example, remains one of the most attractive, exciting investment opportunities, in our view. To a large extent, Chinese consumers have already emerged from the pandemic and there is already a very large middle class looking to spend their money on better experiences, products and services. This appetite has created a premiumization opportunity in the heart of the consumption story.

Looking forward, however, the earnings outlook for companies and regions is dependent on a range of factors including the US-China relationship, global health care outcomes, and the reopening of economies as societies try to achieve some form of normalization.

Emerging Markets Key Trends and Developments

Stocks worldwide began 2021 on a strong footing as markets eyed increased US stimulus following Democrats’ Senate election victories. However, the uptrend stalled in the face of potential delays to the stimulus package, stock valuation concerns, and a resurgent pandemic amid slow vaccine rollouts and the spread of new coronavirus strains. EM equities held onto gains in January, while developed market stocks finished lower. The MSCI Emerging Markets Index increased 3.1% during the month, while the MSCI World Index declined 1.0%, both in US dollars.1

 

The Most Important Moves in Emerging Markets in January 2021

Emerging Asian equities outpaced broader EMs in January. East Asian markets were largely buoyant. Both Taiwan and China posted better-than-expected economic growth for 2020 and were among the few markets in the world to avoid a contraction during the pandemic. Taiwan benefited from strong technology exports. China’s economic showing helped investors look past new COVID-19 clusters, tighter regulatory oversight of the internet industry, and US-China tensions. Conversely, Southeast Asian markets mostly retreated. The Philippines recorded its worst full-year economic decline in 2020, while the detection of a new coronavirus variant in the country drove market caution. Malaysia declared a state of emergency and widened movement restrictions amid a jump in COVID-19 cases.

Latin American markets were among the weakest in January. Except for Chile, which edged out a tiny gain, all the markets in the region recorded declines. Weaker domestic currencies and profit-taking following a strong fourth quarter 2020 were among the key reasons for the decline. Concerns about the country’s fiscal position and COVID-19 situation coupled with weakness in the real weighed on Brazilian equities. The country’s central bank maintained its key benchmark rate and stressed the importance of maintaining monetary stimulus to support the economy amid the pandemic. Supported by strength in the external sector, the Mexican market, however, outperformed the wider region. The economy also reported faster-than-expected gross domestic product growth for the final quarter of 2020.

Equities in the Europe, Middle East and Africa region recorded mixed returns with the Middle East and Africa region outpacing their European counterparts. The United Arab Emirates market ended the month with double-digit gains, driven by the progress in the rollout of the vaccine to the population and news that the government could increase foreign ownership in the telecommunication sector. Plans to begin the administration of vaccines in South Africa coupled with expectations of re-openings in parts of the country, as the number of COVID-19 cases continued to decline, boded well for the equity market. Despite higher oil prices, Russian stocks fell in January, partly due to a weaker ruble. Mass protests across the country and geopolitical noise weighed on investor sentiment.

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. Smaller and newer companies can be particularly sensitive to changing economic conditions. Their growth prospects are less certain than those of larger, more established companies, and they can be volatile.

 

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1. 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.

 

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