Was 2020 a turning point for Emerging Markets?

Rarely has consensus been this optimistic about Emerging Markets (EM). Expected to benefit from a vaccine-led recovery, strong cyclical rebound, and weaker dollar, many market participants are looking for EM to outperform in 2021. To that end, weekly inflows into EM equities hit an all-time high two weeks ago. This also comes after a strong year – MSCI EM, the most used EM equity benchmark, was up 18.7% in 2020, outperforming the S&P 500 (+18.4%) and MSCI Europe (+5.9%), beating Developed Markets (DM) for the first time since 2017.¹ 

However, in times prior to the arrival of the COVID-19 pandemic, expectations of EM outperformance have often led to disappointment. Despite stronger growth and supportive demographic and consumer trends, EM equity returns averaged 3.6% per year over the period from 2010-2019. Even EM Asia, the favored region of the EM universe, only returned 3.5% per year over the same period. Last year marked a departure from the norm – EM Asia, specifically Northeast Asian markets, were the best performing equity markets globally, with China, Taiwan, and Korea all up around 40% on the year. This raises the question – was the pandemic-related outperformance only temporary; a flow-on from effective virus containment? Or does it represent a structural shift in which global investors recognize Asia for the key role it plays in the global technology supply chain – especially semiconductors? In other words, after a decade of flat earnings and market underperformance, could this be a lasting inflection point for EM?

What drives EM performance?

While Emerging Market economies often have more differences than similarities, investors should still consider the common factors that drive broad EM performance and the key drivers for specific regions. For broad EM, when global growth is cyclically improving and the U.S. dollar is broadly weak, Emerging Markets tend to perform well. Global investor flows into EM also generally follow a widening of the EM-DM growth differential and a weaker dollar.

This makes intuitive sense. Nominal growth tends to drive returns, but only in an environment where high nominal growth doesn’t result in undue currency depreciation. As a result, the two biggest predictors of EM performance tend to be 1) exports and 2) commodity prices. Why?

1) Exports are usually the most volatile part of the EM growth cycle, driving swings in corporate earnings growth, regardless of what is happening domestically. Exports are not only a big direct driver of earnings growth across the broad EM universe, but strong exports can also support economies’ currencies. In other words, exports are a strong driver of earnings and FX appreciation, both of which are crucial for investment returns in EM. 

2) Other than exports, the second main dynamic to understand is the commodity-EM relationship. At first glance, there shouldn’t be a significant correlation. EM is no longer a significant commodity producer: commodities account for only 30% of EM exports, which is only slightly higher than the DM share of 20%. Furthermore, EM is not a net commodity exporter –  it hasn’t had significant commodity surpluses in decades and has long been driven by manufactured goods exports. It is also important to note that commodity-related industries make up only approximately 20% of MSCI EM market capitalization. That said, there is a clear correlation between commodity prices and EM growth, but more importantly, between commodity prices and EM exports. And as mentioned above, EM exports are the single biggest predictor of EM asset performance.  

If commodities are no longer an important part of EM economies, why does this relationship exist? It’s not so much that commodities are driving the cycle, but rather that commodity prices often reflect global growth and risk appetites, which are reflected in both exports and commodity prices. Together these largely determine the path of currencies, equities, and other asset markets. Broadly speaking, understanding the potential path for EM exports and commodities bodes well for determining the path for EM assets. In this respect, we are expecting healthy EM export growth over the first half of 2021, healthy current accounts, and resilient commodity prices. As a result, the EM-DM growth differential should improve this year. By this count, it makes sense to favor EM in 2021.

The last point worth considering is the link between EM as a risk asset class and global risk appetite, often exhibited by the value of the U.S. dollar and the value of other commodities. A strengthening dollar tends to coincide with falling commodity prices, pressure on EM currencies, widening EM spreads, and underperforming EM equities, while a weakening dollar corresponds to higher commodity prices and a relative EM rally across the board – regardless of what is happening with underlying fundamentals. As mentioned above, a weaker dollar is generally associated with capital flows into EM assets.

Country fundamentals matter

While the above is meant to provide a framework for thinking about broad EM performance and the drivers of flows and asset performance, country fundamentals matter, especially for investors taking specific country risk. At the individual country level, macro fundamentals differ greatly across EM. Generally speaking, countries with higher nominal growth prospects and healthy current accounts have performed the best (in other words high nominal growth, in dollar terms). Beyond individual country allocations there are other considerations for investing in EM. As mentioned above, there are huge differences across the group of economies referred to as “Emerging Markets” and understanding the different dynamics and drivers can boost returns and improve portfolio diversification. 

In this respect, there are two distinct camps with clear characteristics in terms of currency and market performance: 1) the commodity bloc and 2) the manufacturing bloc. Understanding this can help investors add diversification to a portfolio, particularly in regions like Asia where most investors already have significant regional exposure. The commodity bloc largely consists of South America, Africa, Russia, and the Middle East; and the manufacturing bloc broadly consists of Asia, Central and Eastern Europe, and Mexico. While there are common drivers across EM, these two underlying blocs have very different characteristics and macro drivers. In particular, the cycle for the manufacturing bloc moves largely in line with the DM cycle. DM import growth is a significant factor and the asset markets of EM Asia and Eastern Europe are well correlated with global equities. However, the commodity-driven economies have offered more diversification and higher beta to an environment of improved risk appetite and strong cyclical growth. In particular, with expectation of further US stimulus, especially infrastructure stimulus, these parts of EM could see outperformance. 

As a final point, parts of Asia have emerged as a “semiconductor bloc” -- notably Korea and Taiwan -- where those markets are increasingly reflecting the significant role their companies play in producing the world’s most significant product.  These two economies were previously noted for their very high correlation to global trade and DM import demand. Furthermore, their low trend rates of growth have resulted in relative underperformance against the rest of EM. However, with semiconductors now found in everything from electric vehicles to 5G base stations, the structural demand for semiconductors has increased and is expected to increase further. These two economies are among the world’s largest producers of these irreplaceable components, and increasingly these economies’ markets are less driven by the global cycle and more driven by the semiconductor demand cycle. Part of this surge in demand is clearly a result of COVID-accelerated megatrends, but a clear question facing investors is how to treat the market of Korea and Taiwan on a forward-looking basis. Structurally, as semiconductor production becomes more concentrated and demand is expected to remain strong, there is an argument for a separate allocation from other aspects of EM. 

What does this mean for investors?

We favor EM assets in the year ahead due to expectations of global cyclical recovery, a weaker dollar, improving trade, and upside in commodity prices. Within EM, we favor equities over bonds, though bonds still offer attractive yields on a relative basis, and FX appreciation could help local currency bond returns. Last year, Northeast Asia outperformed due to (1) virus containment, (2) “new economy” stocks being helped by COVID-driven acceleration in structural megatrends, and (3) strong semiconductor demand. This year, we prefer the beneficiaries of a structurally weaker USD, such as industrials, financials, and materials. We also continue to like IT on the back of structurally stronger semiconductor demand. Geographically, we still favor Northeast Asia structurally, as well as value/cyclical economies, such Hong Kong, SE Asia (Singapore), India, Brazil, and Russia. A weaker USD also tends to bode well for high-yielding EM, and we favor currencies such as the Mexican Peso, Chinese RMB, and Russian Ruble in the FX space. 

Note:

¹ all performance numbers are in USD terms. 

All market and economic data as of January 18, 2021 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.

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• Past performance is not indicative of future results. You may not invest directly in an index. 
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INDEX

• The Standard and Poor’s 500 Index is a capitalization-weighted index of large-cap U.S. equities. The index includes 500 leading companies and captures approximately 80% of available market capitalization. 

• The MSCI Europe Index captures large and mid-cap representation across 15 Developed Markets (DM) countries in Europe

• The MSCI Emerging Markets Index captures large and mid-cap representation across 26 Emerging Markets (EM) countries. With 1,198 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

• The S&P GSCI Commodity Index serves as a benchmark for investment in the commodity markets and as a measure of commodity performance over time. It is a tradable index that is readily available to market participants of the Chicago Mercantile Exchange. 

• The MSCI Taiwan Index is designed to measure the performance of the large and mid-cap segments of the Taiwan market.

• The MSCI Korea Index is designed to measure the performance of the large and mid-cap segments of the South Korean market.