Q1 2021 NEWSLETTER

A lens on emerging market equities

19-Feb-2021
  • Gordon Fraser, CFA
  • BlackRock

View through the prism of our investment process

Emerging market (EM) equities defied early gloom last year and ended with double -digit gains, outperforming developed markets1. The 2020 total return for the MSCI EM Index, 18.3% in U.S. dollars, reflected strong global fiscal and monetary supports, China’s economic rebound, vaccines signaling gradual improvements ahead and some optimism about an earnings recovery in EM.

The pandemic truncated the normal economic cycle, but we believe EM economies have been resilient and an upturn may be relatively swift.
Equity performance has rewarded healthcare and tech-related stocks; we’ve gradually adopted a more cyclical bent, moving into financials and leisure.
The outlook for a recovery in 2021 is now consensus, but positioning seems less consistent, opening up potential investment opportunities.
Quotation start

“EM countries enjoy decent fundamentals and have defied calamitous predictions regarding the pandemic.”

Quotation end

Market overview and outlook

We are constructive on EM equities for several reasons: 1. Strong liquidity, easy financial conditions and high levels of disposable income underpin expectations for positive earnings growth (see chart below); 2. Covid-19 vaccines support the gradual resumption of normal economic activity; 3. the pandemic-related stimuli have been proportionally  less taxing across most developing nations relative to developed peers; 4. the weaker U.S. dollar has helped EM economies attract foreign capital; and 5. recent flows into EM equities reinforce this view, which we see extending in 2021.

Three signposts to watch

  1. Recovery. Large economies following China’s path can help lift the global economy.
  2. Market breadth. “Momentum” stocks that drove equity returns last year (high tech and healthcare) may lose appeal reflecting a shift in valuations and earnings expectations.
  3. Geopolitics. A possible broadening of U.S.-China tensions from trade to human rights issues, albeit the tone and tactics may be less contentious under the new leadership.

    Turning tide

    Consensus earnings expectations, 2018-2022
Consensus earnings expectations, 2018-2022

 

Source: Reuters, as of end October 2020. Based on 12 month past and forward earnings per share (EPS) ratios. The MSCI EM Index is a market capitalization weighted index covering about 85% of the free float adjusted in each country. NTM (next twelve months) refers to EPS figure that is being fore casted for the immediate next twelve months from the given date. The graph shown relate to past performance There is no guarantee that any forecasts made will come to pass. Past performance is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy.

Focusing on what matters

Covid-19 ushered in a new decade for the world and will be remembered for its disruption to lives and livelihoods, globally. But this pandemic should further be remembered for fast-tracking trends already underway in social attitudes towards working and learning (more remote access), spending (more online shopping/services) and investing (more emphasis on environmental, social and governance, ESG, issues). We believe these trends are here to stay and remain at the forefront of our minds as we apply the investment tools we’ve developed to help navigate current and future market environments.

Last year’s volatility complicated equity investing, but other extremes required equally astute judgments. For example, the dichotomies between an expectation that emerging economies would be hardest hit versus the actual outcome, or the bifurcation of sector performance that benefited a limited group –growth-oriented, internet-related or new technology stocks –to the detriment of more established and visible sectors.

These challenges enabled us to test our focus on data sciences, risk management and market composition as ways to refine our investment decision-making. We touch on each to illustrate how they played out last year, and why these areas will remain integral to our investment process.

Data mining

Popular belief suggested that Covid-19 should have hit developing economies disproportionally hard, but our data scientists monitoring the situation evidenced facts pointing in the opposite direction. Fatalities in developed countries, mostly in the western hemisphere, outpaced those in developing ones by about four times between March and September 2020, based on counts per one million people. What contributed to this relatively controlled outcome?

China, South Korea and Taiwan became world champions at finding, testing and isolating people effectively. Many EM countries went for herd immunity strategies by default, with large populations contracting the virus, and have generally fared better than many developed countries despite having inferior healthcare systems.

Our stock-picking methodology, based on analysing company fundamentals, has increasingly relied on data scientists within our team to corroborate or reject our investment theses. We’ll continue to adhere to this practice and enhance it over time.

Risk management

The momentum style dominated stock returns last year, with high tech and healthcare driving most indexes’ performance –see A widening gap graph. But stock prices can’t go up forever, and vaccines and the end of lockdowns will lead to normalcy and may expose certain valuation anomalies.

To balance portfolio risk, we turned to our dedicated EM equity experts in BlackRock’s Risk and Quantitative Analysis group to understand risk exposures and identify what we considered an appropriate mix in seeking to add alpha over this turbulent year. We’ve held growth and momentum stocks while progressively shifting to sectors that should benefit from normalization: the unloved financials and leisure-related stocks that have drawn our attention lately due to low valuations and improved earnings prospects.

In an increasingly sophisticated world, we regard the close relationship with our risk management experts as critical to understanding portfolio risks and cementing our foremost ambition of creating a sustained alpha for our clients.

A widening gap

EM stock returns by investment style, 2016-2020 

EM stock returns by investment style, 2016-2020

 

Source: BlackRock, FactSet,as of end December 2020. Quintile spread refers to the difference between five data sets, representing 20% each of the universe of cumulative returns from December 2016 to December 2020. Universe MSCI EM ex A shares. The figures shown relate to past performance. Past performance is not a reliable indicator of current or future results.

Market composition

The face of EM has changed dramatically since the 2008 global financial crisis, and more changes are brewing. China has effectively controlled the virus and managed a challenging period for its economy. Its share of world exports rose to about 14% last year, a new high thanks to global spending in technology and Covid-related protective equipment. But domestic consumption has risen steadily and played a large role in last year’s V-shaped recovery, adding more than 50% of China’s GDP and up from 2019 levels.

Another salient change is the rise of internet giants that have drastically reshaped index composition and size. The changing face of EM graph compares the top 10 MSCI EM Index constituents recently and in late 2008. Alibaba, today’s largest, and Tencent, second largest in the index, were not even in the picture back then, and only two have remained in the top 10 —TSMC (Taiwan) and Samsung Electronics (South Korea). 

This fast-moving scene brings new challenges about index risks and concentration, but also potential opportunities. China’s rise as an investment destination seems inevitable, yet we don’t see any single country monopolizing performance and have continued to identify potentially rewarding opportunities in India, Mexico and elsewhere in EM. The internet giants are also facing headwinds from increasing regulatory pressures and more intense competition, which undermine their potential to keep growing at the same breakneck pace.

Our focus on generating unique investment insight, aided by our data scientists and risk management experts will remain vital inputs for our decision-making.

The changing face of EM

MSCI EM Index’s top 10 holdings, 2008 and 2020

MSCI EM Index’s top 10 holdings, 2008 and 2020

 

Source: UBS, BlackRock, November, 2020. 2008 data as of Oct. 31, 2008, and 2020 data as of Nov. 30, 2020. Reference to the company names mentioned in this communication is merely for explaining the investment strategy and should not be construed as investment advice or investment recommendation of that company.

Portfolio positioning

Industrial activity and discretionary consumer demand led China’s V-shaped economic recovery, and we believe the trajectory will remain healthy. However, the central bank has started tightening monetary policy, and the strong performance in the onshore and offshore equity markets suggest this is a time to be quite selective.

We believe India’s economy will continue to recover and have a positive view on ASEAN countries –especially Indonesia, where we see an attractive entry point given the premium growth and yield this country can offer.

In Latin America, we maintain our preference for Mexico over Brazil, although we have started to reduce our under-exposure to Brazil, which we consider a good source for cyclical exposures, with attractive valuations and very low ownership as incentives.

Markets in EMEA remain interesting, as they should benefit from the large European fiscal stimulus directed primarily at infrastructure spending. This is feeding into significant stimulus in Eastern Europe, for the first time in years. 

In short, we believe global investors have an opportunity to expand into EM equities at good entry point given the attractive growth and yield relative to DMs, at a time valuations and ownership remain low.

Gordon Fraser, CFA
Co-Head of Global Emerging Markets Equities
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Stephen Andrews
Stephen Andrews
Co-Head of Global Emerging Markets Equities