The development of safe, effective vaccines and a weak U.S. dollar solidify our constructive view of emerging market equities, and undemanding valuations further burnish their appeal. We maintain our long-standing preference for Asia (ex-Japan).
It’s been a long year of turmoil and turbulence, but the development of COVID-19 vaccines allows us to end the year on a note of optimism. Much of the newsflow about the vaccine rollouts and their positive impact on the recovery has focused on the U.S. and Europe, the genesis of these innovations and among the first nations to roll out the protection against COVID-19. The UK is the first country in the West to have already started its vaccine campaign.
The vaccines will be a shot in the arm for emerging markets (EM) as well. Rollouts are widely expected in the second half of next year. Some Asian countries enjoy a well-established health care infrastructure and should have little difficulty with vaccine logistics.
For many EMs, however, distributing the vaccine is a tall order, particularly in view of the ultra-cold storage requirement of the Pfizer/BioNTech vaccine (-70 degrees Celsius). The rollout of the Ebola vaccine in 2003 provides a somewhat encouraging precedent: it was successfully distributed in parts of Africa, despite requiring a similar storage temperature. Vaccines with less complicated logistics may well become available down the road too.
One can be forgiven for thinking that as the vaccines are initially rolled out in advanced economies, EMs stand to lose out. But that is not necessarily the case.
Many EMs, including Thailand, South Korea, and Turkey, rely heavily on exports, accounting for a hefty 60 percent, 40 percent, and 33 percent of GDP, respectively. So, as the global cycle picks up, these economies should benefit. Countries like Thailand, Mexico, and Turkey, which generate 23 percent, 16 percent, and 12 percent of GDP, respectively, from tourism, could enjoy an incremental recovery on the return of freshly vaccinated tourists.
Our national research correspondent points out that EM equities tend to outperform when global Purchasing Managers’ Indexes, gauges of economic activity, increase thanks to companies’ high operating leverage or high fixed-cost base, and because of pronounced exposure to cyclical sectors, which account for some 50 percent of the MSCI Emerging Markets Index.
EMs as a whole have been severely affected by the pandemic, based on daily new confirmed cases. However, Asia has made progress reducing infection levels due to the early, stringent measures in several countries. Over the past two months, the surge in daily infections in developed markets has surpassed that experienced in EMs. India’s infection numbers, which seemed to spiral out of control midyear, are falling, even as Europe and the U.S. grapple with a second and third wave, respectively.
Early this year, many, including us, were concerned that the COVID-19 outbreak could spark a new EM financial crisis with a wave of defaults and devaluations. These fears have proved overblown. Thanks to authorities, including the International Monetary Fund, stepping in, that situation has been avoided. Vaccine rollouts in EMs should further underpin the EM economic recovery, even though the rollouts will happen later than in developed nations.
According to the Organization for Economic Co-operation and Development, emerging market Asia will top the economic growth leaderboard in 2021, thanks to China, which is expected to grow eight percent in 2021, while India should come in just under that at some 7.9 percent. Latin America is likely to lag, with Mexico growing 3.6 percent and Brazil an even more meagre 2.6 percent.
Weak greenback, strong emerging markets currencies
The prospect of a weaker USD is another key reason why we’re constructive on EM equities.
Since vaccine breakthroughs were announced in November, investors have become increasingly confident in the return of economic growth. A less fearful outlook is visible in the performance of the U.S. Dollar Index, which has weakened by four percent against a basket of major currencies in that time. Since the peak of the COVID-19 crisis in March, the Dollar Index has weakened by some 12 percent.
According to consensus forecasts, dollar weakness could persist into 2021. Ultra low interest rates could make the dollar less attractive, while more predictable trade policies under a Joe Biden presidency could further dull the greenback’s lustre as a “safe-haven” currency.
As investors gain confidence in the global economic outlook, they will likely seek higher-yielding assets. Q4 2020 is already shaping up to be one of the strongest quarters for inflows into EMs since 2013, with non-resident portfolio flows totalling some $76 billion in November, significantly above October’s $23 billion. These capital flows are likely to continue as EM currencies are undervalued and government bond yields are higher.
According to our national research correspondent, EM currencies are nearly as undervalued as they were during the Asian financial crisis despite some countries’ balance of payments surpluses being close to a 20-year high. In addition, the interest rate on EM local government debt compared to that of the U.S. is significantly higher, even adjusting for inflation. This higher spread should attract foreign investors.
Moreover, Chinese government bonds will be included in the FTSE World Government Bond Index in October 2021. This reflects China’s ongoing progress with market reforms and increased access for global investors. China is the world’s second-largest bond market with some $16 trillion outstanding. According to our national research correspondent, foreign investors own only three percent of Chinese government bonds against a benchmark weighting that could potentially rise to approximately 15 percent.
A conducive environment
Strengthening EM currencies and undemanding equity valuations underpin a constructive case for EM equities.
Historically, there has been a distinct positive relationship between strong currencies and equities. Our national research correspondent finds that over the past 15 years most EM equities have outperformed as currencies in these countries strengthened. This occurs because a stronger national currency makes it easier for EMs to cope with heavy external debt loads, which our national research correspondent estimates at around $5.2 trillion.
EM equities also appear undervalued. Our national research correspondent calculates that on a sector-adjusted price-to-earnings basis, EM equities trade at a discount of some 20 percent to developed markets, close to a 15-year low, with most sectors trading at a discount to their developed market equivalent. Looking at price-to-book value shows a similar picture, with EM equities trading at a 30 percent discount to developed markets.
For China, we believe the current valuation looks fair, with the onshore index, the CSI 300, trading at 14.7x the consensus forward earnings estimate, in line with the five-year average.
Risks to this constructive outlook include a difficult vaccine rollout and a take-up that’s too low to allow social-distancing measures to be relaxed in both developed nations and EMs. Perhaps less likely, a decision by the Federal Reserve to tighten policy sooner than expected would also upset the outlook. Countries that have ratcheted up debt to finance government spending, such as Brazil, would be particularly vulnerable, in our view.
Overall, we believe that the prospects for EM equities look attractive for 2021. They’ve had a good run recently, surpassing their year’s high, achieved in January, and the MSCI Emerging Markets Index is up 67 percent since the March lows, in line with the gains generated by the S&P 500. Better entry points are possible, but on a one-year view, we are positive on the asset class, with a preference for Asia (ex-Japan), and China in particular. Having weathered the COVID-19 crisis more successfully, this region’s finances make it less vulnerable to an eventual Fed tightening cycle.