Monthly Investment Letter: The re-emergence of emerging markets

This post was first shared on ubs.com/cio. Visit the website for more UBS CIO investment views.

The economic and social changes in emerging markets (EMs) over the past two decades have been extraordinary.

EM countries now make up over 60% of total global economic output, and account for over 70% of global GDP growth. They consume the majority of the world’s oil, copper, and iron ore as well as accounting for the bulk of global car sales and cell phone subscriptions. Since 2000, over one billion people in emerging economies have moved out of poverty, while the number of billionaires has increased more than three times faster in EMs than in the developed world.

Investors exposed to these developments have been well rewarded. Over the last 20 years the annualized equity return for the MSCI Emerging Markets index, (which we use to define the EM universe) has been 7.2%, compared with 5.2% for the MSCI World. And, since the inception of the MSCI EM index in 1988, EM equities have outperformed global equities by about 2ppt per annum. Meanwhile, since 2000, the JP Morgan EMBI Global Diversified sovereign bond index has delivered annualized returns of almost 9% compared with less than 5% for US Treasuries.

In recent years, however, the EM story has changed.

Between 2014 and 2019 EMs failed to shine, as their aggregate growth advantage over developed markets (DMs) shrank. Equity markets have lagged correspondingly. Last year, total returns were less than 19%, compared with 27% for the global index and 32% for the S&P 500. Indeed, since mid-2007, EM equities have returned just 55%, compared with 260% for the S&P 500. Investors, tired of the underperformance, have voted with their feet. EMs’ share in global mutual fund assets is currently just 7% compared with an average of 9% historically.

Yet we now think it is time for investors to start reallocating to EMs.

First, we expect the growth differential between emerging and developed markets to widen in EMs’ favor. Second, valuations in EMs are lower than in DMs. Finally, many of the greatest identifiable secular trends in the coming decade of transformation are going to play out in EMs.

We are therefore now taking the majority of our tactical risk in EMs, across stocks and currencies. This month we maintain our overweight to EM equities, as they should outperform developed market stocks.

We also add to our overweight position in EM currencies within our FX strategy, adding a position in the Brazilian real to our existing position in the Indian rupee and Indonesian rupiah. That said, we now see less of an opportunity in US dollar-denominated EM sovereign bonds, given recent spread compression, and close our overweight position there. The asset class remains a valuable part of our strategic asset allocation, but the tactical outlook is more muted and may be at risk in a downside scenario.

We are monitoring the coronavirus* risk closely, and at this time do not believe it warrants portfolio action.

EMs: Not what they used to be

Many investors think of EMs as fast growing but exposed to “old economy” sectors like materials, energy, and utilities. Financial crises in individual countries, such as Turkey or Argentina, also reinforce the historical idea of EMs as current account deficit countries, highly dependent on external financing, or volatile commodity exporters vulnerable to shocks.

Yet the make-up of EM equities has changed significantly. Back in 1994, materials, financials, telecommunication, and utilities accounted for around two-thirds of the index. Today, the index instead is dominated by IT/communications services, financials, and consumer discretionary, which together account for almost two-thirds of the benchmark. The technology and communication services sectors’ 27% weighting is almost double that of the materials and energy sectors combined.

In 1995, the total market capitalization of MSCI EM equities was equivalent to one-third that of Japanese equities, and Asia accounted for less than half of the index market capitalization. By 2019, EM capitalization represented 171% of Japan’s market capitalization and more than 10% of global equity market capitalization. China’s market share has risen from zero to more than 30% of the index’s value, and Asian markets in aggregate now comprise 74% of the overall index. The phased inclusion by MSCI of China A shares could also create a technical tailwind as fund inflows increase with index weighting.

The tilts toward Asia and toward technology leave EMs well positioned to benefit from the key secular growth trends that will drive our coming decade of transformation (see box out). Furthermore, provided investors diversify, volatility in EMs is manageable. Many investors we speak with are surprised to learn that the volatility of the EM index (14.6% over the past three years) is in fact similar to or lower than many individual stocks considered to be stable, such as Nestlé (12.3%) or Novartis (16.1%).

Relative growth set to pick up

Although healthy exposure to secular trends should help EM performance, we must acknowledge this performance has historically been closely tied to the growth differential to DMs. The low current growth differential partly explains why EM equities have underperformed DMs in recent years.

But the outlook is more positive.

We forecast that the growth differential between emerging and developed economies will increase from its recent plateau of around 2.5ppt toward 3.5ppt this year. The benefits of a Phase 1 trade deal should accrue more heavily to EMs as a whole than to the US. Manufacturing bore the brunt of the negative impact from trade tensions and those sectors account for 11% of US GDP, but 21% for EM economies. This is already becoming evident in the data. December manufacturing sentiment surveys continued to improve modestly in EMs, while the US manufacturing ISM fell to a post-2009 low. The EM growth outlook is also supported by accommodative central bank policy and our expectation for a weaker dollar this year.

We also expect this growth outperformance to continue into the medium term.

In high and upper-middle income countries working-age populations will likely peak between 2020 and 2025, meaning lower rates of GDP expansion. In contrast, a young and growing population is an important driver of growth in some EMs. Other sources of higher growth potential include the ability to incorporate technological progress into local production processes, often in combination with competitive labor markets, and the ability to provide or attract funds for infrastructure investments.

________________________________________________________________

EMs in the decade of transformation

Water scarcity is one of the key themes of the coming decade, and this will play out strongly in EMs. China and India represent 35% of the world’s population, yet have access to less than 10% of its freshwater resources. The ongoing global trends of urbanization and population growth exacerbate this imbalance as their effects are concentrated in the developing world. We therefore expect continuous revenue and profit growth for the entire water value chain.

The expansion of megacities in EMs is driving demand for infrastructure investment. EMs are forecast to account for almost two-thirds of global infrastructure spending by 2025. In addition, adjustments to supply chains resulting from US-China trade tensions will likely increase infrastructure spending in some countries. We recommend diversified exposure, including through the water value chain and the MSCI Emerging Markets Transportation Infrastructure Index, which is geographically diverse, and has a low correlation to US dollar trends.

We believe public investment in healthcare in EMs will pick up in the next 10 years due to aging populations and the rising demand for modern healthcare services by the growing urban middle class. We expect EM healthcare investment to increase at double the rate of global healthcare over the next decade, and also to outpace EM economic growth. In particular, we are keeping a close watch on genetic therapies, which we believe represent a paradigm shift in medicine, with the potential to revolutionize healthcare delivery and disrupt the biopharma industry. In the US, four approved therapies have sales equivalent to USD 1bn on an annualized basis. But, notably, in 2018 one-third of global CAR-T trials—an approach to harness the power of the body’s immune system to fight cancer—were conducted in China.

We expect the combination of 5G, artificial intelligence, big data, and cloud computing to define a new era of digital transformation and innovation around the world in the decade ahead. And EMs are at the forefront of this trend. Taiwan’s recent auction of 5G licenses attracted USD 4.6bn, a record sum relative to its population size, while South Korea has already begun rolling out 5G networks (alongside the US and the UK), and in November, China’s three state-owned mobile operators launched 5G services in 50 cities.

Although environmental, social, and governance (ESG) regulation in EMs is often less robust than in DMs, this also means investors are likely to place a greater premium on those EM companies with higher ESG standards. The MSCI EM ESG Leaders index has already outperformed the broader MSCI EM index by more than 3% annualized (since inception at end-September 2007 to end-September 2019).

________________________________________________________________

Earnings trends favor EMs

EM equities are not especially cheap on a historical basis: they are currently trading at a 30% valuation discount to the S&P 500, close to the 10-year average of 27%. However, given that valuations across almost all markets are above 10-year averages, and near early 2018 peaks, we think that earnings, rather than valuations, are likely to become the primary driver of returns going forward. This dynamic should favor EM equities.

Regionally, we expect the highest rates of earnings growth in 2020 to be in Asia ex-Japan (13%) and Latin America (15%), compared with just 6% in the US and a 2% contraction in the Eurozone. And we expect this earnings growth premium to persist over the coming decade. We think DM equity returns are likely to be much lower than in the last decade – we expect 4–6% nominal returns per year in DMs in local currency terms. However, in EMs we expect roughly 9% annual returns in USD terms, largely thanks to better potential for long-term profit growth.

Despite some slowing in Chinese economic growth, overall EM economic growth is forecast to remain higher than in DM countries, which will help EM companies achieve higher revenue growth. In addition, in the US profit margins are close to record levels but in EM margins are in line with their longer-term averages. So, we see less of a headwind from potential downward profit margin adjustment.

________________________________________________________________

EM equity preferences

Within EM equities we prefer Chinese stocks. After slowing last year, China’s economic growth is stabilizing: December industrial production, retail sales, and fixed-asset investment all beat consensus estimates. Monetary and fiscal policy remains supportive: the People’s Bank of China has cut the reserve requirement ratio by 50 basis points this month and we expect a further 50–150bps of RRR cuts this year as well as 10–20bps of medium-term lending facility rate cuts. And corporate earnings momentum is improving: upgrades are outnumbering downgrades, and we expect earnings growth of around 10% this year, driven by consumer-linked sectors.

We also recently opened an overweight position in Brazil, a rare “early cycle” story in a world of maturing growth, as the country transitions from a state-led to a market-driven economy. The recovery should drive superior earnings growth (20% vs. 13% for EMs based on our estimates), and we think a continuation of reform momentum will drive Brazil’s valuation premium to EMs from current levels of par to 10%. Record low real interest rates are also supporting domestic and international funds’ allocation to equities, while potential BRL appreciation could also provide an additional source of upside.

We see potential for double-digit returns from Indian equities over a 12-month horizon. We expect a pick-up in GDP growth this year and next and revived momentum in pro-market policy reforms by the government. Most importantly we expect corporate earnings growth of 22.6% in FY2020 and a still impressive 15.6% in FY2021.

________________________________________________________________

How to invest in EMs

Equities

We maintain our tactical overweight to EM equities versus US government bonds.

• We continue to prefer EM equities over other regional equity markets such as the US and the Eurozone. The US continues to deliver superior earnings growth to the Eurozone but relative valuations are becoming stretched, limiting the upside potential. By contrast, EM equity valuations are not as extended and the region offers faster earnings growth. In addition to expected double-digit growth in corporate profits this year, earnings revisions in EMs (the balance of upgrades versus downgrades) are positive for the first time in two years. With signs of stabilization in the global economy, we also note that EM equities have tended to outperform following a trough in global PMIs.

Bonds

We close our overweight to emerging market USD-denominated sovereign bonds against US government bonds.

• A backdrop of easy monetary policy, low global yields, and muted global growth has supported the asset class, and credit spreads have compressed. We now think it is time to take profit on this position, preferring to keep our risk allocation to equities and currencies in emerging markets.
• Nevertheless, we continue to stress the importance of holding EM USD-denominated sovereign bonds from a strategic standpoint. They offer strong risk-adjusted returns and attractive yields, while providing portfolio diversification. Since 2000, the asset class has been one of the best-performing within fixed income globally, with an annualized return/annualized risk ratio of over 1. EM countries facing default and/or the need for debt restructuring, such as Argentina this year, create headlines and may reinforce preconceptions about EM assets. But the JP Morgan EMBI Global Diversified sovereign bond index comprises 170 issuers from 73 countries, creating ample diversification. Argentina, for example, represents just 1.5% of the index. The credit quality of the asset class has also generally improved over time, and is now about 54% investment grade.

Currencies

In our FX strategy, we add to our overweight in a basket of high yielding emerging market currencies.

• We believe the current FX market environment, characterized by all-time low volatilities, central bank accommodation, and low DM interest rates, is conducive to carry trades, supporting EM currencies.
• In our FX strategy, we hold an overweight position in the Indonesian rupiah (IDR) and the Indian rupee (INR), funded by short positions in the Australian dollar (AUD) and the Taiwan dollar (TWD).

• This month we add a long position in the Brazilian real (BRL) against a short position in the Swedish krona (SEK). The BRL offers a nominal carry of 3.7%, relatively low in an EM context, but still sizable when paired against the low yielding SEK. Economic activity is improving in Brazil, with growth expected to pick up to 2–2.5% this year (from 1% last year), while implementation of further reforms should support sentiment. Sweden’s central bank, meanwhile, has hiked rates back to zero, but we expect no further increases. The decision to hike was motivated by the desire to abandon negative rates rather than evidence of strong economic data, and the macro outlook in Sweden remains weak. We also believe that long SEK positions were built up ahead of the rate hike, leaving the SEK more vulnerable to depreciation.

Tactical Asset Allocation

Elsewhere in our tactical asset allocation:

We open an overweight position in the British pound versus the US dollar in our FX strategy.

• The UK will formally leave the EU by the end of January and enter a transition period for the rest of the year. Sterling has weakened from its December post-election highs on concerns that a new trade deal won’t be agreed by the end of 2020 and by hints of a rate cut by the Bank of England. But we think any rate cut would be near term and one-off.
• We also expect a limited trade agreement to be reached by December, and emerging clarity on the UK-EU trading relationship should support sterling. The US dollar is also likely to weaken as the year progresses as trade tensions ease, just as rising tensions strengthened it. We see sterling’s recent dip as a good buying opportunity to hold the pound over our tactical investment horizon; we expect GBPUSD to rise to 1.40 by end-2020. Meanwhile, we maintain our longer-term commitment to sterling by no longer currency hedging our strategic exposure to UK stocks.

________________________________________________________________

*Monitoring the coronavirus in Wuhan

The breakout of a virus in Wuhan, China, has already caused multiple casualties, just ahead of the Lunar New Year holiday, when around 450m people are expected to travel across China and abroad. Much remains unclear regarding the severity of the virus and how fast it is spreading.

The initial response by the authorities to this outbreak has been relatively swift – Wuhan and neighboring cities are now subject to a travel ban – and there is now widespread public awareness due to the number of media reports covering the subject.

Past experience in the region may offer some guidance as to the potential economic and market impact, though the response was not as fast as in today’s case. The SARS outbreak in 2003 lasted for eight months as a health risk, but led to a sharp fall in Chinese economic growth over just one quarter, followed by a swift recovery. The time-to-recovery for the Asia ex-Japan market was just two months.

We remain alert for an increase in the severity of the outbreak, although at this time we do not think it warrants portfolio action. We are inclined to view the drop in Chinese stocks, and the wider MSCI Asia ex-Japan market, as an opportunity to add exposure to these markets. Recent data shows that fundamentals in North Asia, particularly in China and Taiwan, are picking up.

________________________________________________________________

Please visit ubs.com/cio-disclaimer #shareUBS