Yet Another Year of Bullish Emerging Markets Calls? Why This Time Is Indeed Different
Exogenous factors often knock well-positioned markets temporarily off track, sometimes repeatedly. But dislocated share prices ultimately re-align with business fundamentals, earnings growth and attractive valuations.
Investors raising an eyebrow toward this year’s bullish emerging market outlooks could be forgiven for their skepticism. They have, after all, heard about the same structural drivers in recent years, without the expected results 12 months later. The outbreak of a pneumonia-like virus in China doesn’t help.
Both sell-side strategists and buy-side fund managers are optimistic about the prospects for developing country and frontier market stocks this year. In Bank of America Merrill Lynch’s January Global Fund Manager Survey, emerging markets were the “number one consensus” equity overweight over the next 12 months. At the same time, survey respondents didn’t view the asset class as currently among the most crowded trades.
As Global Perspectives also pointed out in our EM outlook, we think emerging markets are both fundamentally and tactically well positioned for the year ahead. And while we’ve noted the structural drivers previously (here and here), perhaps analyzing why some previous forecasts haven’t quite panned out as expected is relevant to assessing why circumstances are even more favorable this time around.
Markets often sweep stronger and weaker stocks in tandem up or down. The coronavirus emanating from China, for example, has done just that globally, pushing equities worldwide lower and safe-haven assets higher. Exogenous factors frequently spark such broad market moves, which cause share prices to dislocate from firms’ business fundamentals.
Detours and Speed Bumps
The dislocations can sometimes last for extended periods. In 2014 and 2015, for example, commodities prices plummeted, broadly dragging down emerging market stocks even though much of Asia, and especially China, are net commodities importers and benefitted from the hefty declines in energy and base metals prices.
Then, from mid-2016 to late 2018, tightening U.S. monetary policy caused the U.S. 10-year Treasury yield to jump from 1.36% to 3.24%, forcing a sharp rise in domestic EM borrowing costs as local central banks had to tighten policy in the Federal Reserve’s wake to counter the weakening in their home currencies and check potential imported inflation. EM economic growth slowed as a result.
The Fed, of course, did an about-face and became more accommodative in 2019, but a busy EM election calendar, including balloting in India, Indonesia, South Africa and Argentina, weighed on sentiment. That political risk overhang related to EM general elections has now lifted for the next couple years.
More transient events also cause market dislocations. Take the four previous global viral outbreaks: Avian Flu, SARS, H1N1 and Ebola. “History shows that after a viral fear recedes, markets do see a V-shaped (equity market) recovery,” Cornerstone Macro points out. Although that’s not a lot of history to go by, these previous events turned out to be buying opportunities.
Coronavirus and Prognosticating a Spring V-Shaped Recovery
The current coronavirus outbreak in China is likely to get worse before it gets better, despite Beijing’s quarantines of numerous cities. That’s because asymptomatic transmission may be occurring, and China’s far more developed than it was during the SARS outbreak in 2003, facilitating the current virus’ spread. “China’s transportation infrastructure, including high-speed trains, is much more built out than it was back then, not to mention its fleet of well over 300 million motor vehicles, the largest in the world,” said Thornburg Portfolio Manager Lei Wang, who just returned safe and sound from three weeks of research in China. “Another difference is social media, which was non-existent 17 years ago and sharply magnifies people’s anxiety, which tends to depress economic activity.”
In an internal research note, Thornburg’s emerging markets strategy team points out that “shutting down major cities and restricting travel across the country will have notable short-term ramifications on GDP.” It adds: “We expect downward revisions in Chinese growth estimates for at least the next one-to-two quarters. With populations in city centers hesitant to go out, consumer discretionary businesses, along with those tied to the travel sector (e.g. hotel, lodging, airlines, etc.), are likely to be the most impacted.”
Yet for Wang, who runs international equity strategies, and the emerging markets team, the current coronavirus-related dislocation presents potential long-term buying opportunities of Chinese and non-Chinese companies with operations or significant sales in the world’s second-largest economy. Valuations on select Chinese and other emerging market companies just became even more attractive, particularly on those with resilient or growing earnings, conservative balance sheets, free cash flow and durable moats.
A Policy Booster Shot for Markets
The health care team at Citic Securities, China’s largest investment bank, expects the virus’ spread to peak in late February or early March and end in April or May. If a V-shaped markets recovery then materializes, those are the types of companies that will compound off a higher base than their lower-quality peers. But most Chinese firms will benefit from the likely tax relief and monetary support to come from Beijing, given the virus’ impact on GDP in the current quarter.
The Fed and other major central banks are also far more likely to remain in accommodative mode to offset the likely near-term decline in China’s contribution to global growth. A stable dollar should allow for emerging market earnings growth to shine through amid stable or appreciating local currencies and lower borrowing costs in many countries.
If 2020 has gotten off to a rocky start, there’s still plenty of reasons to expect this year to build strongly on last year’s 19% total return in the MSCI Emerging Markets Index, particularly for those who invest selectively in the best of the best emerging market stocks.