Before Covid-19, the emerging market economies like China, India, South Korea and Taiwan were seeing an economic surge as tens of millions of people joined the middle class every year. Many economists expected these countries to enjoy another banner year in 2020 as more of their citizens turned into consumers.
The pandemic ripped up that script, and countries like India and Brazil continue to face enormous setbacks and devastating human losses.
As it did everywhere else, the pandemic exposed the huge gaps between have-nots and haves. It also accelerated trends already in motion, such as the desire to avoid stores and shop at home: Consider the yawning gap between those countries in best stead to fight the pandemic, graced with technology companies that allowed them to roar back to economic life.
Think, specifically of Asian countries like South Korea, China and Taiwan, which had those advantages in spades. These countries benefited from strong healthcare infrastructures, mobilized testing and contact tracing, and were already used to life-saving masks. Thus these countries were among the first to navigate the crisis and emerge with their economies in better shape, say portfolio managers.
The crisis upended the tech landscape overseas too, allowing the entrance of new companies and broadening the investment opportunity set. But while tech was the big success story, as the world reopens, consumer cyclicals, materials, energy and commodities have also started to regain their vitality—and those sectors have long been associated with the success of the emerging markets.
John Paul Lech manages the Matthews Emerging Markets Equity Fund, a general EM fund that Matthews Asia launched last year after keeping its focus mostly to Asia before. He notes that vaccination rates in different countries—particularly the infrastructure required to get needles into arms—will likely determine the reopening rates. “If you look at rates of vaccination, you’re upwards of 40% in a place like Chile and in Peru it’s like 2%.”
But all the puzzle pieces have been shaken up. Even if a middle class continues to emerge in these countries, Covid has likely put unstoppable changes in motion. “You go to a hotel in Mexico next year. How many people are needed in that check-in process?” Lech asks. “Has that changed structurally because digitization—or themes like that—were accelerated during Covid?”
Meanwhile, he says, older consumers in these countries who had never bought things online before now might realize they don’t have to wander back into stores. “I’m less worried about the eventual recovery of economies,” Lech says, “and more about how does the next normal potentially differ from what we were accustomed to in pre-Covid times.”
Take India, for example, where Lech has a stock holding in the IT services space. “If you’re able to have most of your workforce at home and you’re really delivering services to a global clientele base, that is a completely different thing than a company that requires a lot of movement and sale of non-essential items. I think India’s recovery, like a lot of different places, is going to be business-model dependent.”
Aash Shah with Summit Global Investments, whose global strategy includes emerging markets companies, says stimulus packages and QE in every central bank have helped all the markets, especially emerging market countries. But he adds that countries like India and Brazil have been the most affected by the virus. India had reported 26 million cases and 291,000 deaths by mid-May, while Brazil had 15.89 million cases and more than 444,000 deaths.
Shah also says that there’s likely a stark amount of undercounting in the deaths in India. “They just don’t have enough testing kits. They don’t have supplies. They don’t have oxygen cylinders. And they don’t have vaccines.” The International Monetary Fund had anticipated a 5.8% economic growth rate in India in 2020, but that recently changed to a 7.7% contraction.
But emerging markets look cheap by United States standards, he says, and that’s a tailwind for these countries, whose companies’ valuation multiples shine by comparison.
In March, Goldman Sachs said that the next-12-months price-to-earnings ratio for emerging markets was an attractive 15.4x, while it was 23.5x for U.S. markets. But the earnings are going to depend on how well countries have handled the crisis.
“Ravaged by the pandemic, 2020 was an exceptional year by any standard, witnessing both the sharpest recession and, in a lot of EM, the strongest recovery on record,” Goldman said in its March report. “Going in to 2021, we argue that much of the heavy lifting would need to be done by earnings per share growth.”
Shah does point to one red flag in emerging markets, however—and that’s food inflation. He notes that the agricultural commodities subsection of the Bloomberg commodities index was up 72% year over year in early May. Rising world food prices hurt in places where people spend a greater proportion of their budget on food, as they do in EM countries. That can cause political turmoil, he says. “Food inflation is going to ravage those households much more than in the Western world. … If you remember in 2010 and 2011, you had the thing called Arab Spring, that was highly coinciding with the food inflation that they say was basically a contributing factor to the discontentment of the population.”
As the world rebuilds, industrials and materials companies should do better in emerging countries, Shah says. That’s especially true as housing market takes off in the U.S. and EM countries can feed the demand for exports like lumber, copper, aluminum and steel.
The financial services sector is tricky and depends on where you play. Chinese financial companies like Ping An and China Life Insurance haven’t taken off, Shah says, because they’re state-owned enterprises, and despite the dividends, you aren’t sure what you are owning. India, on the other hand, is a country where the home mortgage industry is taking off and only 15% of the population is under a mortgage (most people still live in multi-generational homes, he says). Also, the World Bank put the country’s unbanked population at 190 million, and researchers have suggested that half the existing bank accounts are inactive.
“So consumer financing companies, and that means banks and shadow banks that provide credit, those will continue to do well. … Banks generally do well when the yield curve steepens.” Indeed, the 10-year Treasury yield has tripled from 50 basis last summer to 174 at the beginning of April. “What that means is that banks generally borrow at the low end of the curve, keep money, and lend it out at a little bit higher rates, and obviously when rates were really low, that was a flatter yield curve, banks were less profitable. As the rates have gone up on the long end, the yield curve has gotten steeper.”
It’s also gotten steeper because of the semblance of global growth in the U.S. and elsewhere. So he thinks that financial services will do well both in the U.S. and abroad.
Roddy Snell, an investment manager on the Baillie Gifford emerging markets equities team, says he’s very bullish on the emerging markets and there’s a dramatic period of change afoot where a lot of Western money is going to come to these countries, where he thinks the balance sheets and cost of capital are more sensible. He says 10 years of technology business growth was compressed into six months’ time because of the Covid crisis, putting a number of companies in strong competitive positions.
Silly Videos, New Players
Who might have thought that silly videos on TikTok might help the economy?
The acceleration of tech use amid the Covid crisis have opened up huge opportunities for e-commerce companies, Snell says. “Just like SARS back in 2002, 2003 really gave birth to the Chinese internet giants that we see today [like Alibaba], I think Covid will do the same for internet companies and usage across emerging markets. And you can see that in a place like Indonesia, where there is one company called Sea, which seems to be now the dominant e-commerce company definitely across Indonesia, and really looking like it’s going to dominate most parts of [the Association of Southeast Asian Nations] over the next five to 10 years. It’s originally a gaming company backed by Tencent. They started an e-commerce business called Shopee.” Other success stories are China’s online grocery delivery and retailers such as JD.com and Meituan. The latter’s stock price soared during the pandemic after a reported 400% surge in online grocery delivery, he says.
“If you go to China, you see a new rung of technology companies really coming to the fore during the crisis,” Snell says. “So your Tencents and Alibaba, which have sort of been dominant for a decade, have really seen a pickup in competition in the likes of Kuaishou, which is a short-form video company, and ByteDance,” the No. 1 short form video platform (and TikTok’s owner). These companies have seen explosive growth, he says, and ratcheted up a 50% market share of social media advertising, “which I don’t think anyone would have expected three or four years ago.”
Still A Middle Class Play
The key driver of the emerging markets is still the growth in the middle-class consumption in the Asian countries, especially China, but that’s largely been overlooked because of the success of the American equities market. Again, Snell thinks that story is set to change if these countries are better set to come out of the crisis in the next 10 years. China will be less dependent on exports. Also, if the U.S. and Europe launch big infrastructure projects, the emerging market economies should benefit.
“We think materials look incredible interesting at the moment,” Snell says, where he says the firm has an overweight. “We have big positions in copper and nickel. This is really a play on the green revolution, which appears to have been accelerated by Covid. … Copper is great in that because it really is the new oil. The green revolution cannot happen without the best conductor in the world. And nickel, which we’ve had holdings in for several years, is a crucial element in electric vehicle batteries.” If China ramps up its electric car fleet to its ambitious goals of 30% or more, he says, “there will simply not be enough nickel in the world today.”
Brian Nick, chief investment strategist at Nuveen, says that his firm likes EM for the rest of the year, since the firm doesn’t see a lot of central bank tightening and emerging market currencies have improved this year (as of early May), and when there are expansions in global manufacturing in the developed world, it’s going to spill over to emerging markets. The firm has been overweight in Latin America and the consumer sectors, adding to discretionary consumer. “We’ve been adding to countries like Brazil, which obviously didn’t work in the first quarter, didn’t work well at the end of last year. Some of that is a valuation story. We’re willing to be patient on the overweights. Some of it was taking some profits in Korea and Indonesia where we were market weight [or] overweight.” But he says that EM might not outperform other sectors that are bouncing back, such as U.S. small-cap stocks.
Tom Wilson, head of the emerging markets equities team at Schroders, agrees that countries making up two-thirds of the benchmark, China, Korea and Taiwan, managed the Covid crisis very well, and contributed to its strong performance. These countries also benefited from the heavy presence of tech stocks in their benchmark composition, he says. Tech benefited from the trend everywhere for people to work from home, which helped hardware companies, the semiconductor space, memory names and e-commerce, gaming, etc., he says.
Other countries were more vulnerable and Covid made them more so. “Brazil, for example, where you saw quite a marked escalation in government debt to GDP as a function of their quite a generous support program for households.” The countries more exposed to cyclical and vulnerable stocks like travel, tourism, restaurants, suffered until the vaccine news hit the front pages. At that point, companies that could rebound in earnings started to ramp up—Wilson points to banks and energy stocks.
“You began to see a marked rotation and cyclical recovery from the beginning of November onwards driven by vaccine news flow and expectation of normalization,” he says. With the cyclical stocks rebounding, the vaccine news hitting the papers and commodities rebounding, money started to turn around and flow back into the EM space last fall.
That river has begun to slow to a stream since the beginning of the year, however, according to the Institute of International Finance. The view at the beginning of the year was that the dollar was going to depreciate, said Wilson, which helps emerging markets. But the dollar has stabilized as of mid-May. And, banks aside, the 10-year Treasury bond rising is not necessarily good for the emerging markets, It’s “a headwind for long-duration cash flow,” Wilson says. “So for structural growth names where a lot of the value sits further out, if the long end of your yield curve is going up, your discount rate is lifting and so you’re discounting those long-dated cash flows at a high level. Ergo, your fair value is going to be impeded by that, so then you began to see the steam come out of some of the structural growth names,” Wilson says.
Jin Zhang, a portfolio manager at Vontobel Asset Management, says his firm likes companies with pricing power that can deal with rising commodity costs and thus protect their margins. “That’s what you want as the shareholder. You want the company to be able to protect their margin in a rising rate environment. Many of these consumer companies can do that.”
Besides Meituan, he also mentions Chinese alcoholic beverage company Wuliangye and a snack food company there called Chacha, companies that boast brand recognition among a hungry and homebound customer base. Both these names saw their stock prices double over 2020.
“I would say from a structural perspective, I’m still more interested in the newer industries, i.e., consumer and technology as versus the old industries [such as commodities and energy] that used to dominate the EM index like the Petrobras of the world. That change is still there. I’m not sure of the durability of the commodities rally. We’re definitely still very much emphasizing the consumer companies, the middle-class story.”