The prospects for emerging markets relative to their developed counterparts appear to be improving, but this has not been fully reflected in performance in the last year. The US dollar has weakened, which provides a favourable tailwind, while the most important Asian economies – notably China – have emerged from the pandemic with limited economic damage. At a time when growth is likely to be hard to come by in developed markets, the stronger growth rates in emerging markets should be compelling for investors.
To date, however, investors have yet to catch up. Only over the last few months have emerging market indices started to reflect the more positive backdrop. At the Aberdeen Emerging Markets Investment Company, we believe we are only in the foothills of a recovery for the asset class.
As we see it, a lot of investors are still approaching emerging markets with the view that they will buy in the future. However, good entry points are seldom clear. Investors who have waited have already missed out on some of the rally. The right time to move back in is seldom when everything looks rosy.
The weaker US dollar is the biggest single positive factor for emerging markets at present. Emerging market investors have been waiting for many years for signs of weakness, but momentum for the dollar has only grown stronger. This has seen an abrupt reversal over the spring and early summer as concerns over the spread of Covid-19 and political instability have come to the fore. The importance of a weaker dollar for emerging markets may have been overshadowed by the pandemic, but as headlines shift, we believe investors may start to pay closer attention. Diversifying currency exposure at present, given the fiscal response to the crisis in developed markets, makes intuitive sense.
Another reason investors may not be embracing the opportunity is that some emerging markets are still conspicuously failing to manage the pandemic. Countries such as India, Brazil or South Africa have struggled to contain the virus and are suffering humanitarian and economic consequences as a result. However, this needs to be set against countries such as Taiwan, South Korea and China, which are far more advanced in returning to pre-Covid levels of social mobility and economic performance.
This has been reflected in the superior performance of stock markets in these countries year to date, but this has also been driven by a skew towards technology companies on local exchanges. Even where investors have returned to emerging markets, they have tended to back the beneficiaries of the pandemic.
In valuation terms, emerging markets aren’t at the cheapest levels we’ve seen, but they remain notably cheaper than their developed market equivalents. Earnings are down, but not catastrophically, with stimulus packages and lower interest rates providing support. Some areas, such as frontier markets, look extremely good value having been hit by liquidity concerns. We retain a meaningful weighting to select frontier market assets within the portfolio. This includes exposure to frontier market bonds and African equities.
We also see a broader, macroeconomic consideration for emerging markets. There seems little doubt that developed market economies will emerge from this crisis with significantly greater debt burdens. This is likely to restrain economic growth. In general, emerging market sovereign balance sheets are in better shape. They have less debt and more scope to stimulate if required. This is particularly the case in Asia, where we have been increasing the Company’s exposure.
The final element deterring investors may have been the ongoing saga of US-Chinese trade negotiations. There was a lot of anti-China rhetoric in the run-up to November’s US presidential election, but all eyes are now on the strategic approach that the Biden administration-in-waiting will take. That said, China is in a strong position. Its debt profile couldn’t be more strongly contrasted with that of the US and we believe high debt in the US may eventually start to compromise its economy. We hold a China bond fund in the portfolio: not only does this provide an attractive yield, but we believe investors should have exposure to the Chinese currency alongside the euro and dollar to reflect a shifting global power balance.
A final note on income. Income stocks have been particularly hard hit by the pandemic, with widespread dividend cuts around the globe. In aggregate, emerging market dividends have held up relatively well, which is likely to be recognised by investors seeking yield in what looks set to be a low interest rate environment for many years to come. We have several holdings in the portfolio that stand to benefit should that occur.
As we see it, investors haven’t yet caught up with reality on emerging markets. However, as the influence of the pandemic ebbs and they look at how the world has changed, they may soon seek to capture the asset class’s longer-term appeal.
Emerging market performance has lagged developed markets over the past few years, but there are early signs of a shift.
Emerging markets have seen a short-term rally, but many investors are waiting for the ‘right time’.
The weaker US dollar is the biggest single positive factor for emerging markets.
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