Emerging Markets: Under the Radar

From Laggard to Leader?

Emerging market shares, one of the most unloved asset class in 2021, have had a strong start to the year and several indicators point to the trend accelerating as the year progresses. The EM cohort fell 2.5% last year dragged down by Chinese equities and lagged developed market stocks by 24%, the most since 2013.  That could very well change this year. Rising confidence in global central banks’ ability to tame tearing inflation and China stimulus is seen propping up EM stocks. A weaker outlook for the dollar, low real yields, strong earnings momentum for EM stocks, favorable relative valuations and the likelihood of growth stocks coming back into favor in the latter part of the year is also set to play a role for EM.

As the Flow Goes…

Already smart money is cherry picking beaten down but fundamentally strong assets. EM stocks have held up well so far this year, despite the volatility, and lag only record beating commodities and UK’s FTSE 100. Portfolio flows have matched or exceeded deployment into developed market assets. EM stocks account for more than four-fifths of iShares global volumes. We specifically see opportunities in quality, cyclicals and view EM financials as a good hedge against inflation. In terms of Asian geographies, China (both onshore and offshore where value is in play), Indonesia (reopening trade, value and accommodative policy) and Thailand look interesting.

Foreign investors have been taking money out of EMs ex China. Their light positioning also paves the way for rotation in. For instance, since 2017, they have taken out $60 billion from EM Asia ex-China including $34 billion last year. So far this year’s inflows have reached $4.5 billion. With China’s rise and inclusion in benchmarks, inflows into the nation have exceeded $200 billion in the last five years.

iShares flows this year have been dominated by EM, which accounts for 84% of all net new business (albeit a small notional number due to YTD broad outflows) compared with 3.2% in the last three months of 2021 and 10.6% for the whole of last year.

What’s in EM? Changing Composition

The EM universe has rapidly changed with the inclusion of China, the world’s second largest economy and capital market, into global indexes. EM Asia now accounts for almost four-fifth of MSCI EM Index up from just over 60% in 2014 with the changes led by new economy stocks. In contrast natural-resources heavy Latin America has seen a steady decline, making up less than a tenth of the benchmark from almost a quarter seven years ago.

The ten biggest stocks in the universe account for a fourth of the index with TSMC and Tencent the largest constituents followed by Samsung Electronics and Alibaba. The change in composition is both a bane and boon given the index has missed out on the tail wind from the commodities rally but then it is well positioned to capture the return to tech stocks later in the year. Once the reopening theme fades, growth stocks, especially beaten down Chinese tech, should come back into play with earnings growth for the Chinese internet giants forecast to top 30% in the coming year.

Earnings Expectations

While earnings revisions are expected to move lower globally, EPS estimates for EM stocks have been moving in tandem with their developed market peers whilst significantly underperforming when it comes to equity returns. EM stocks are seen expanding profits by 30% vs 35% for DM. The main difference here is that after multiple quarters of profit growth by US tech, Q4 earnings season should see a significant pullback in earnings revisions. A slower EM return to full economic normalcy vs DM, in combination with less hawkish EM central banks should support EM earnings in 2022, driven by a revival in China tech profit growth.

Compelling Valuations

This is a big factor that is set to act as a tailwind.  The valuation of EM equities has become more supportive with MSCI EM's 12-month forward P/E currently at 12x. This compares to 15.8x in February last year and right on the 10-year average. It is well below the 20.4X for the S&P 500 and 18.4x for MSCI Developed.  The premium that S&P 500 stocks have over EM on a PE basis touched the highest this century late last year though the number has budged down a tad this year.

China Factor

Chinese equities have seen a major de-rating in the past year amid the regulatory crackdown on private enterprise, particularly the technology sector.  Now with the economy slowing, multiple factors are set to come into play which can boost the EM universe.

The crackdown has likely peaked and that will allow investors to focus on fundamentals and companies to concentrate on growth. Authorities are also opening the stimulus spigot as growth begins to slow. This month the People’s bank of China unexpectedly cut a key lending rate and signaled it stood ready to roll out measure ahead of the market curve to ensure stability. The nation’s embattled property developers are also seeing some relaxation with parts of their funding—advance booking of apartments—restored albeit with restrictions. Earnings momentum in China is correlated to EM performance as is the credit impulse. A gauge of the impulse after dropping since the start of 2021 has begun climbing again. Since 2010, China has had four episodes of credit impulse and each time EM have gone up by at least 1% month on month.

Weakening Dollar?

The mantra sell the dollar for assets including EM stocks is gathering pace. With global growth picking up and authorities confident of keeping economies open even amid surge in the virus is raising the question whether the dollar has peaked. We are likely to see a phenomenon where a weaker dollar could push investors to hunt for assets elsewhere. With a confluence of factors set to support EM stocks, it could be time to prepare to build up such assets. The US dollar is undoubtedly important for EM equities, with a particularly strong inverse correlation since 2014. The US dollar is the world’s reserve currency (for now) and thus emerging countries tend to borrow in dollars. Their liabilities and borrowing costs become stretched when the US dollar appreciates or expectations for US rates move higher, but Asia (~75% of EM’s weight) has a very low proportion of its debt denominated in dollars, buttressing its ability to withstand rising US rates.

Real Rates

While long-term global bond yields are rising sharply, real rates are not. The rise in bond yield is driven largely by the term premium, or the extra compensation investors demand for the risk of holding government bonds. As such we believe that ‘real yields’ will remain historically low amid rising inflation and strong growth. This underpins our preference for risky assets such including EMs. Besides markets including India, Taiwan China, South Korea, Brazil all have a negative correlation to rising yields.

Risk Factors

The key risks to our assumptions include a surge in global inflation globally, and pushes borrowing costs sharply. A sharp slowdown in China that saps demand for goods and services across the region with trade increasingly reliant on o the world’s second largest economy. EM nation’s including South Korea, Brazil, Malaysia, Thailand and Russia count China as their top trading partner. Finally, a flare up in the virus or a new mutation that evades current vaccines and forces swathes of the EM economies to shut down.