Dec 14, 2020
We expect a much more normalised environment in emerging markets (EM) during 2021, with both equities and debt benefitting from a less confrontational US trade policy, a lower-for-longer approach by the US Federal Reserve and a global economic recovery.
For EM equities, we think there will be a broadening of market performance, with less divergence between value and growth returns, while debt could benefit from the region’s stronger growth potential and higher relative yields.
Archie Hart, Portfolio Manager, Emerging Markets Equity
2020 was an extraordinary year for markets across the globe and emerging markets were no exception. Over the last 20 years, there have been six big volatility events affecting performance in markets, two of which – the COVID-19 pandemic and US election – occurred this year. This drove an extremely narrow market leadership and some of the highest correlations we have ever seen in emerging markets. Only three out of the 26 regional markets – China, South Korea and Taiwan – made gains in the first nine months of the year. This outperformance was driven by these economies’ ability to manage themselves out of the coronavirus pandemic. Similarly, only four out of the 11 sectors delivered positive performance – health care, communication services, technology and consumer discretionary – with eight out of the top 10 stocks related to technology or the internet. These top ten companies drove all the emerging market return over the first three quarters (Figure 1), leaving around 1,400 names which performed poorly1.
Figure 1: Technology- and internet-related stocks dominate market returns in 2020
Source: Factset, MSCI Emerging Market index returns, 30 September 2020.
This is not a buy, sell, hold recommendation on particular securities.
Markets became optimistic on positive signs toward vaccine development and green shoots of economic recovery, which drove a broadening out in market performance in the third quarter. Five out of the 26 markets outperformed while most of the sectors delivered positive returns. We expect this broadening out in performance across sectors and countries to continue in 2021 alongside less correlation in markets, as economies recover from the pandemic. Those hardest-hit economies, including countries in South America and South East Asia, may see a rally as they recover further.
With light at the end of the COVID tunnel, there have been rallies in value stocks, but we don’t believe all value stocks and sectors will be off to the races just yet. Perhaps, there will be less divergence between quality growth and value performance and a much broader market in general. However, there is still positive operating momentum in the winners of 2020. If you look at technology- and internet-related stocks, forecasts for 2021 earnings growth are up to 20%. Earnings upgrades are beginning to come through in cyclical stocks, with analyst expectations too pessimistic in some cases. There may be high growth in some rebounding areas, such as materials, transport, travel and consumer discretionary. Investors should be selective and focus on company fundamentals, as some rallies could be short lived and driven by sentiment. In terms of portfolio positioning, we have taken some exposure out of technology and re-allocated it to those areas which have lagged and that have significant recovery potential, such as banks, some consumer recovery stocks and airports.
However, we believe there will be a lot of near-term market volatility over issues such as the US presidential handover, the vaccine introduction and spikes in COVID cases. In the second half of 2021, we expect the markets to settle more as the world turns its focus to a post-COVID world and the nitty gritty of how companies and countries are really faring. This should be a conducive environment for stock pickers like ourselves.
More optimism does not necessarily mean that markets will be less discriminating. 2020 saw a number of countries reschedule their debts in 2020, including Zambia, Ecuador and Argentina. There will be emerging market countries that struggle to balance their books in 2021. The second order impacts of the pandemic on economies are coming through, with the outbreak exposing fractures and inefficiencies in economies. This is reflected in protest movements spreading across parts of Latin America and Eastern Europe. Peru has seen three presidents in a week, while Chile has decided to rewrite its constitution to what will almost certainly be less business-friendly terms.
The advent of COVID-19 has stimulated a rush towards populism and such political instability is usually accompanied by currency volatility. Historically higher interest rates have cushioned volatility in more troubled countries, but record lows in interest rates globally means such protection is absent. This is a risk if things go wrong, but it can also work as a positive. In Turkey, after interest rates were hiked to control inflation, a strong stock market and currency rally followed. We believe divergence in emerging market equity performance will be a feature of markets in 2021, partly as the focus turns to the withdrawal of stimulus.
The coordination in COVID-related economic impacts crippling developed markets has been matched by their extraordinary stimulus response, which we will have to wean ourselves off eventually. This compares to less stimulus seen in emerging markets and so we expect that there will still be divergence between emerging and developed markets, presenting opportunities for investors to secure diversification in portfolios.
The dark cloud of pandemic news has also obscured some of the positive developments in emerging markets. The Brazilian development bank has sold down holdings in listed companies, which is positive for market development. Financial reforms in India and China have continued. China, Japan and Korea have all committed to carbon neutrality; a notable positive given they contribute a significant part of global emissions. 2021 presents an opportunity for the market to focus on such individual developments that will be key to returns next year and beyond. The renewable energy transition is a multi-decade long trend and we have a number of companies that are well positioned to benefit from this.
As the largest part of the EM universe, China’s trajectory will be key to emerging market investors. Markets will be focused on the new US president and corresponding relationship with China. We believe the new administration does not change the status quo, as there is broad bipartisan support in America to be tough on China. While we expect the new president to be tough, we believe he will be more practical, pragmatic and rational in action. If the US-China temperature cools, that should be relatively positive for emerging markets as markets respond well to more stability. Outside the US, China has had a busy year geopolitically. Nevertheless it has progressed towards its promised economic reforms despite geopolitical headwinds; China's economy has rebounded vigorously from COVID-19 and so it will be interesting to see how it adjusts its policy to the new presidency in the US.
In our view, 2021 represents some uncertainties, but also significant opportunities for investors as the world begins to see past the pandemic. After the seesaw of 2020, we expect a much more normalised market environment with broader market leadership, which should be supportive of balanced approaches such as 4Factor. We believe that with such normalisation markets should again start to appreciate company fundamentals.
1 Source: Factset, MSCI Emerging Market index returns, 30 September 2020.