EM outlook: Will nuance make a comeback in 2021?
2020 has been largely about the pandemic and its derivatives. Uncertainty of the timing and contours of normalization in industries, economies, and countries has resulted in reflexive efforts to embrace “certainty” in 2020. Growth stocks have been clear beneficiaries of the two big trends in financial markets under COVID-19 – negative real rates and great economic uncertainty.
These twin forces have made extrapolation of the future incredibly challenging for investors, leading to a relentless search for certainty in obvious “digital” winners. Add to that a powerful case of FOMO (fear of missing out) and you have the ingredients for worrying levels of concentration and pockets of structurally overvalued companies.
COVID has fueled growth stocks
Emerging market (EM) growth stocks have had an unprecedented run versus value over the past decade. The pandemic has amplified the run of growth stocks and, in our view, led to pockets of excessive valuation. COVID-19 has essentially amplified trends that were already underway in emerging markets and accelerated the prospects of e-commerce, fintech, food delivery, ride-hailing, gaming, cloud, and other similar digitally driven companies.
In many cases, the assumptions of what these disruptive growth companies can deliver and the valuations they have reached have become untethered from reality, in our view.
Imagination is a critical trait in creating differentiated portfolio results, but much of the hyperbolic gravitas is conventional wisdom, divorced from rigorous diligence. The herculean assumptions being made to justify current valuations often fail to appreciate fierce competitive structures across many of these industries and the long and grinding battle companies face in their pursuit of market dominance. FOMO has become the primary investment motivation for many.
Our 2021 outlook for EM
We believe 2021 will be a year of greater nuance and strong currency performance relative to the US dollar across EM equity markets. After 10 very difficult years, we see ingredients for a sustainable bull market in EM equities. We forecast a significant economic recovery, coupled with a weaker dollar environment, that will likely result in solid gains across non-China EM markets.
We see all the ingredients for a “flywheel,” witnessed in previous prolonged periods of EM outperformance, where foreign capital inflows lead to credit creation, capital formation, GDP and formal sector employment growth, along with significant earnings momentum. We see much of Latin America, Southeast Asia and parts of sub-Saharan Africa benefiting from the flywheel.
Meanwhile, we believe the structural bull case for China equities (which represent nearly half of the MSCI Emerging Markets Index benchmark weight and capitalization) will likely persist given superior growth, domestic investor portfolio diversification, and growing access to high-quality new company listings.
We remain bullish on China given our expectation that the largest EM economy will maintain its focus on generating more sustainable growth and see continued evolution of its financial markets. Having generated the plurality of worldwide growth for the past 10 years, we believe China is poised to deliver over 50% of global GDP over the next couple years as the rest of the world slowly recovers from the economic impact of COVID-19.
We have argued for a structural bull market in China in part due to an increasing number of high-quality companies that are listing on local exchanges and potentially offering better investment opportunities for China’s significant, and largely undiversified, pool of savings – which we believe will result in a major asset allocation shift into equities. However, China’s resiliency and growth this year have put it on the radar of many equity managers on the hunt for “certainty,” and those with clear FOMO. We have observed a rapid increase in investor interest in China, most notably from those with little experience and no visible mandate investing there. This heightened attention has led to pockets of excess, in our view.
The case for nuance in EM
We expect appreciation for nuance will return in 2021 alongside a broader economic recovery. Nuanced investing, in our view, can look beyond pandemic economic shock to companies and countries that are well-placed for rapid recovery, and to industries where consolidation may result in improved pricing, margins, and returns.
We see meaningful investment opportunities in industries most directly hit by the pandemic, including hotels/travel, discretionary retail, selective banks and restaurants as industry consolidation coincides with economic recovery. In this pool there are abundant and compelling valuations. This approach also looks to geographies dominated by informal economies like India, the Philippines and Indonesia, which in our view will likely see V-shaped recoveries post-pandemic.
We believe separating truly sustainable growth businesses from those lifted by FOMO (“certainty”) will be critical to success in the post-pandemic era. The price of certainty is simply too high, likely leading to certain losses. In our view, a disciplined focus on investing in high-quality EM companies with durable growth opportunities, sustainable competitive advantage, real options, and appropriate valuations may help avoid common landmines and position investors to potentially generate compelling returns against such a backdrop.
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The risks of investing in securities of foreign issuers, including emerging market issuers, can include fluctuations in foreign currencies, political and economic instability, and foreign taxation issues.
Growth stocks tend to be more sensitive to changes in their earnings and can be more volatile.
All investing involves risk, including the risk of loss.
Diversification does not guarantee a profit or eliminate the risk of loss.
This does not constitute a recommendation of any investment strategy or product for a particular investor. Investors should consult a financial advisor/financial consultant before making any investment decisions.
The MSCI Emerging Markets Index is an unmanaged index considered representative of stocks of developing countries.
The opinions referenced above are those of the author as of Dec. 14, 2020. These comments should not be construed as recommendations, but as an illustration of broader themes. Forward-looking statements are not guarantees of future results. They involve risks, uncertainties and assumptions; there can be no assurance that actual results will not differ materially from expectations.