Mike Jennings

Globe WorldWatch

Is now the right time to be increasing exposure to Emerging Markets?

WorldWatch

With equity markets having rebounded very strongly, it may be tempting to take profits. However, history tells us that becoming contrarian too early can be a costly mistake. 

Executive summary

  • The weak dollar should continue to be a powerful tailwind, supporting EM outperformance over DM
  • EM equities have enjoyed a V-shaped recovery in the second quarter, but continued global growth will likely be a strong catalyst in the second half of the year
  • Liquidity remains very supportive for both real and financial assets, with the world’s major central banks continuing to operate exceptionally accommodative monetary policy
  • EM offers attractive relative value versus DM
  • EM continues to have long-term advantages such as favourable demographics, urbanisation, and genuinely world-leading technology in key structural growth areas

Equity markets have been wrestling between Covid induced economic collapse versus exceptional monetary and fiscal stimulus around the world. This battle will likely continue until a vaccine is widely available. While localised additional lockdowns are a concern, particularly in countries where Covid cases are still elevated, we remain constructive on the outlook for EM equities, buoyed by the recent weakness in the US dollar.

With some asset classes having rebounded very strongly, it may be tempting to take profits. We have certainly been doing this at the stock level in instances where valuations have become stretched, and our constrained capacity allows us to be nimble in this regard. However, at the broader asset class level, history tells us that becoming contrarian too early can be a costly mistake. Whilst bears can point to rising valuations (on depressed earnings) in some parts of the market, asset bubbles have historically only burst once policy was tightened and bond yields rose. This was true in Japan in the early 1990s, and in the Dot Com bubble in the early 2000s.

The end of the Japanese bull market

the end of the japanese bull market

Source: TT International, Bloomberg

The 'Dot Com' bust

The dot come bust

Source: TT International, Bloomberg

However, the current backdrop is very different as bond yields languish at all time-lows, with relentless downward pressure from quantitative easing, which will not end until 2021 at the earliest.

The current picture is very different

the current picture is very different

Source: TT International, Bloomberg

For EM equities there also remains valuation support for the majority of the index, even in the Tech heavyweights (Samsung is on 11x earnings, Alibaba is on 23x, TSMC is on 21x, and Tencent is on 32x, with 15-35% EPS growth).

In our recent piece entitled ‘Taking Stock on the Global Economy’ we discussed the magnitude of the stimulus being provided across the world. The current expansion of leading central bank balance sheets makes the easing efforts of 2008 pale into insignificance and is clearly acting as a powerful depressant for global bond yields.

Expansion of central bank balance sheets

Expansion of central bank balance sheets 820

Source: TT International, Bloomberg

Similarly, the expansion of broad money supply around the world has provided exceptional liquidity that is causing inflation in the prices of both real and financial assets. This is unlikely to abate for some time to come.

US M2 money supply growth

us m2 money supply growth 820

Source: TT International, Bloomberg

The dollar was broadly flat in the first half of 2020, but July saw marked weakness, with the currency devaluing by over 4%. At the same time, commodity prices picked up significantly, demonstrating their time-honoured inverse relationship with the dollar, which can be seen below.

Commodity prices versus the US dollar

commodity prices versus the us dollar 820

Source: TT International, Bloomberg

Although perhaps a little oversold in the short term, we expect dollar weakness to persist in the months ahead, driven by several factors. The dollar is often a safe haven in times of sluggish global growth. However, with emerging economies rebounding strongly and displaying a more pronounced recovery than that of developed economies, this safe haven support is dissipating. The dollar also had strong yield support, especially against the euro, which has now largely evaporated. US election polling also has an important role to play here, with the Democrats taking a strong lead. This should exert further downward pressure on the dollar, given the potential for tax rises and capital outflows. The Fed is also committed to a policy of being ‘behind the curve’ on inflation. Whilst there are plenty of arguments as to why inflation will remain low (demographics, automation etc), excess money supply chasing restricted production capacity may stoke inflation down the line, devaluing the dollar. Trends towards protectionism and greater local production may add further to this pressure. Finally, on most historic metrics the dollar is expensive.

Industrial commodities are beginning to see increasing demand coming through from global (especially Chinese) infrastructure spending programmes. This is especially helpful to Latin American economies as they are big commodity producers. Indeed, the chart below shows a 94% correlation coefficient between commodity prices and LatAm equity returns over the past decade.

Commodity prices versus LatAm equity returns

commodity prices versus latam returns 820

Source: TT International, Bloomberg

As alluded to above, a weak dollar is also traditionally a powerful tailwind behind EM outperformance versus DM. Over the last 30 years, the inverse correlation is clear (weak $ = strong EM), with a 76% correlation coefficient.

US dollar versus EM relative performance

us dollar versus em relative performance 820

Source: TT International, Bloomberg

Given the Covid induced earnings slump in 2020 and a lack of visibility over the recovery in 2021, valuation metrics are more unclear than usual. On reported earnings, however, Developed Markets appear to be testing new decade valuation highs, while Emerging Markets are less extended. On this basis, EM trades at a 31% discount to DM (versus a 20 year median of 27%). This seems unjustified, particularly given the tailwinds of a more pronounced economic recovery in EM, the potential in several Emerging Markets for further monetary easing, commodity price appreciation, dollar weakness, and abundant liquidity.

EM versus DM Price/Earnings ratio

em v dm pe 820

Source: TT International, Bloomberg

With negative real rates across much of the world and huge fiscal stimulus coming through, we expect continued support for global equities and for EM to outperform DM. For the time being, we believe the old investment adage of "don’t fight the Fed" will hold true, particularly as all the other major central banks are also providing ample liquidity support. Volatility around Covid cases, vaccine progress and geopolitics will continue, but the trend should remain a positive one for equities, in our view. Whilst growth stocks (and especially technology) have led the rally, we still believe that many technology stocks offer an attractive combination of growth and value. Importantly, unlike in the US, where many investor darlings have valuations that stretch even the most bullish analyst assumptions, EM offers reasonably priced technology in abundance.

That said, we do expect the market rally to broaden out to encompass some cyclicals. Those related to fiscal stimulus efforts are clear beneficiaries. These include infrastructure plays and commodity providers, as well as some healthcare, technology, and clean energy companies, all of which we have exciting exposure to.

We believe that our Global Emerging Markets franchise is well placed for the environment described above. With top-down forces being such a powerful driver of stock returns at present, and geopolitical tensions seemingly on the rise again, our combined top-down/bottom-up approach should be able to capitalise. Indeed, we aim to pick attractive stocks with sound valuations, while also benefitting from top-down tailwinds and avoiding the riskiest areas of the market. Whilst equity rallies around the world have thus far been driven by the mega-cap technology giants, having the flexibility to hunt further down the market cap spectrum is also useful as many of these stocks have been left behind in the rally and offer strong catch-up potential in our view. Capping capacity, as we do at TT, gives us this flexibility and should provide comfort to our investors that we will not outgrow our style. We unashamedly have higher portfolio turnover than many peers. This is a direct result of our ability to be flexible, and should enable us to have optimal exposure in our portfolio regardless of changes in the political, economic or corporate landscape. Although many uncertainties lie ahead in terms of macroeconomics, geopolitics and indeed public health, we are excited about the opportunity set that we have at our disposal and look forward to the challenge of adding further to our strong and consistent long-term track record of alpha generation.

Important Information:

Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).

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