Reflation Concerns Dampened Investor Optimism in February

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Three Things We’re Thinking About Today

1. The strength of China’s economic recovery is unparalleled, in our view. The skill and speed with which authorities dealt with the COVID-19 pandemic resulted in a V-shaped recovery that we believe bodes well for continued strength in the year ahead. Chinese economic policy will likely focus on normalization throughout 2021, using monetary, fiscal or regulatory levers. We also believe that the depth and breadth of the investment opportunities the Chinese equity market offers have grown exponentially. Digitalization, adoption of technology and further consolidation across certain industries should all feed into the long-term opportunities that we have long been watching unfold in China. More recently, the government’s commitment to achieving a carbon-neutral footprint by 2060 could lead to some interesting opportunities in the renewables space, as well as the electric vehicles sector. The trajectory of companies that have harnessed technology to create online platforms from traditional brick-and-mortar businesses has met some Chinese government initiatives—from lower transaction costs to reaching segments of society that previously did not have that access to goods and services. Looking ahead, the concept of digitalization extends beyond the consumer section in terms of how we consider 5G (fifth-generation wireless) technology, as we believe it could become a tailwind for other sectors to capture this opportunity, particularly in the industrials sector.

2. India’s Union Budget was primarily focused on infrastructure and manufacturing to attract capital and augment sustainable long-term growth. An emphasis on infrastructure development should benefit the construction, infrastructure and cement sectors, while plans to increase the foreign direct investment limits in insurance companies bodes well for that sector. A revival of gross domestic product (GDP) growth, combined with the push on infrastructure and industrial growth, as well as a benign interest-rate environment, could support loan growth, which could benefit banks with sizeable corporate lending activity. While there was a lack of direct near-term catalysts for the consumer sector, we believe that as investment-driven GDP growth picks up so should disposable incomes, in turn boosting domestic consumption. In addition, we remain positive on secular consumption trends and believe well-positioned companies in the sector could leverage their competitive advantages to strengthen their market share in consolidating industries. Overall, we expect India’s economic recovery to continue over 2021, as economic activity gradually settles toward pre-pandemic levels. We see corporate earnings on an uptrend and expect earnings normalization, following the pandemic-related downturn. However, we remain mindful of the risks, including the ongoing pandemic, regional and global geopolitical relations.

3. As we begin to trend toward economic normalization in 2021, a pivot in investor focus toward the importance of company fundamentals has raised expectations that value stocks may make a comeback. One key area that lagged in 2020 on asset quality and non-performing loan concerns as well as falling interest rates, and that could benefit from greater investor interest in 2021, is financials. We believe that financials remain a key area of secular growth given the low levels of credit penetration across the asset class and continue to focus on dominant, well-managed incumbent banks with strong capitalization levels and robust deposit franchises. While the market was swift in discounting earnings in 2020, our belief that the risk of systemic banking crises was low in the majority of emerging markets (EMs) given reasonably strong capitalization, regulatory oversight and current policy support, and less credit expansion as compared to developed markets led us maintain a positive view on the sector. Financials are also trading at attractive valuations versus the wider EM asset class. The MSCI EM Financials sector has a forward price-earnings (P/E) ratio of 9.1 times, versus the wider MSCI EM Index which is trading at 15.3 times.¹ Similarly, the price-to-book (P/B) ratio is also lower at 1.1 times compared to 2.1 times for the MSCI EM Index, while the dividend yield is higher at 3.4%, compared to 1.8%.²

Outlook

While there has been some concern about the sustainability of the recovery rally in global including EM equities, we prefer to focus on the importance of the fundamentals of an individual company rather than get caught up in market euphoria. For us, in addition to valuations and market prices, the key question is whether a company has a sustainable business model that can evolve and improve, rather than become obsolete with the innovation taking place globally.

We continue to see numerous structural opportunities in EMs. These include growing penetration and premiumization of goods and services, which is also linked to the demographics of EMs. There are billions of consumers and economies in different states, but generally, consumers are trying to upgrade.

Newer themes in recent years revolve around the internet, e-commerce as well as the growth of electric vehicles and in renewable energy. Take for example, how solar prices have become relatively cheap, when compared to coal, and as a result is challenging the traditional resource amid lowering energy costs. Moreover, technological innovation continues to grow exponentially—an area in which EMs have significant exposure.

Company engagement is another crucial factor in EM investing. Bringing about better corporate behavior and a better understanding of companies’ responsibilities toward all stakeholders are efforts we continue to push in our stewardship of client capital. And what we have been seeing in EMs over recent years is a significant improvement in corporate governance across a wide range of areas including improved capital discipline, better reporting and greater alignment with minority investors. We believe that all of this could ultimately lead to a potential re-rating of many markets.

Emerging Markets Key Trends and Developments

EM equities headed into February on an upbeat note before reversing course to finish the month with modest gains, trailing developed market stocks. Investors shifted from optimism to caution as improved prospects for more US fiscal stimulus, progress in COVID-19 vaccinations globally, and a stronger outlook for the world economy stoked inflation expectations and a jump in US Treasury yields. Cyclical stocks largely outpaced the broader market. The MSCI Emerging Markets Index increased 0.8% during the month, while the MSCI World Index returned 2.6%, both in US dollars.³

The Most Important Moves in Emerging Markets in February 2021

Emerging Asian equities advanced in February. Stocks in India, Taiwan and the Philippines were among the top performers. India’s government announced an expansionary budget that lifted market expectations for the economy’s longer-term expansion. In Taiwan, officials raised their economic growth outlook for 2021 on the back of strong technology exports. However, China’s market fell. An initial rally riding on the economy’s continued recovery gave way to profit-taking as worries of monetary policy tightening and valuation concerns took hold.

In Latin America, a decline in the Brazilian market pushed the region’s benchmark index into negative territory, while Argentina, Chile and Peru led with solid returns. The surprised replacement of Petrobras’ chief executive officer by Brazil’s president raised concerns of government interference at the state-owned oil company, weighing on the broader market. A deprecation in the Mexican peso erased most of the market’s gains in US dollar terms, while rising copper prices supported returns in Peru and Chile, two of the world’s largest producers of the metal.

Equity markets in the Europe, Middle East and Africa region ended February broadly higher. The Saudi Arabian market was among the top-performing regional markets on the back of an increase in oil prices. Improving COVID-19 trends, the start of the country’s administration of vaccines and continued re-opening of the economy drove South African equities in February. Higher oil prices and a strong ruble coupled with a faster vaccine rollout and accommodative central bank policies supported the Russian market. At the other end of the spectrum, Kuwait, Qatar and Poland recorded declines.

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 Source: MSCI, FactSet. 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 a guarantee of future results. The P/E ratio is an equity valuation multiple defined as market price per share divided by annual earnings per share. For an index, the P/E ratio is the weighted average of the P/E ratios of all the stocks in the index.

2. Source Source: MSCI, FactSet. 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 a guarantee of future results. P/B is a valuation metric that compares a company’s current market price to its “book value,” or net asset value. For an index, the P/B ratio is the weighted average of the P/B ratios of all the stocks in the index.

3. Source 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.