Emerging Markets: Near-Term Uncertainty Matched with Long-Term Opportunity
Emerging Markets: Near-Term Uncertainty Matched with Long-Term Opportunity
While the pandemic has increased near-term risk, the rise of innovative and value-added industries should place the future trajectory of emerging markets on more stable footing, Daniel Graña and Matt Culley argue.
- Disparate responses to the global pandemic are resulting in varying near-term outlooks for emerging market (EM) countries.
- Increasingly, the legacy EM drivers of offshoring and economic convergence are being eclipsed by innovation.
- Despite changes to tech sector regulations in China, we believe authorities continue to recognize the role that tech companies play in increasing efficiencies and providing needed services.
Over the course of 2021, emerging markets (EM) – similar to all countries – have had the trajectory of their economies and financial markets dictated, to a degree, by developments in the COVID-19 pandemic. Anticipation of increasing economic activity pushed EM equities benchmarks to record highs in February. Later, the spread of the Delta variant and the threat of renewed curtailment of commerce exerted downward pressure on the asset class. For reasons explained below, these public health developments should serve as a reminder that EM equities are not monolithic; EM countries’ unique responses to the pandemic will likely be an important determinant in their near-term economic progression and ability to generate attractive returns for investors.
More recently, an important segment of the asset class – China technology – has come under pressure due to a shifting regulatory landscape. While the situation merits monitoring, we recognize what hasn’t changed, which is the innovation being carried out by a host of Chinese companies as they leverage technology to drive productivity gains across the broader economy and, in several instances, create entirely new industries.
We believe that future advancement of EM economies will be driven by innovative, private companies seeking to address the unique needs of these regions’ consumers and business customers. The growing role of innovation in many EM economies is owed to the greater economic stability brought about by years of outsourcing and convergence-led growth across the EM landscape. With clear policy support, we are now witnessing the establishment of what are rapidly becoming essential industries and the ascent of digitally native, middle-class consumers. As seen in Chart 1, industries most closely associated with innovation and a digital economy have seen their share of the MSCI Emerging Market Index1 grow considerably over the past decade at the expense of banking and commodities, which long dominated EM economies.
Chart 1: Innovative industries have gained market share in emerging markets
Source: Bloomberg, Janus Henderson Investors. Industry weightings as of 19 August 2011 and 19 August 2021.
Economic decoupling between China and the U.S. is gaining traction, and the role played by global trade in powering economic growth is likely to diminish. Similarly, state-owned enterprises (SOE) that often lag the private sector in efficiency and can be called on to perform acts of “national service,” such as what we witnessed in several EMs during the pandemic, are likely to play a smaller role in delivering marginal economic growth. Given these developments, actively managing exposure to legacy exporters and SOEs – including avoiding certain securities all together – will likely be an important tool for managers seeking to maximize returns and managing risk in EM equities going forward. That this third “innovation” pillar is gaining momentum as a long-term source of returns is an exciting development for the asset class.
A Playbook for Navigating a Complex Landscape
While we believe the private sector holds the keys to EMs’ future prosperity, other factors are at play as well. Policy casts a long shadow in countries still creating sound economic structures and regulatory frameworks, and corporate governance – especially with respect to minority shareholders’ rights – is an issue that often requires close examination. Given this, we think EM investors should be guided by a multi-lens approach that considers company fundamentals, corporate and political governance and the direction of macroeconomic policy.
Looking forward, within the macro context, we see reasons for optimism as the availability of COVID-19 vaccines and other therapeutics may help address the pandemic and should then lead to a broadening of investment opportunities. At the same time, we see divergence in how individual countries are dealing with the crisis. While some governments have been proactive in distributing vaccines and addressing outbreaks, others have struggled with logistics, new variants and reduced vaccine efficacy.
We believe these challenges could create a wide-ranging spectrum of trajectories for different countries. Those that succeed in combating the pandemic may return more quickly to their pre-2020 economic path. Countries that are slow to roll out vaccines or address uncontrolled viral spread may face longer-term health, economic and fiscal repercussions. India, in particular, has been hard hit by the virus, and as seen in Chart 2, its weak fiscal position limits the government’s ability to support the economy. On the other hand, the north Asia countries of China, Taiwan and South Korea have made more progress in addressing the pandemic. Nonetheless, we caution that the health care crisis is far from over, and new variants and additional waves of the virus remain sources of near-term uncertainty both for the global economy and for many EMs and their fiscal conditions.
Chart 2: Weaker fiscal positions often align with deeper 2020 recessions
Source: IMF World Economic Outlook Database, April 2021.
An Eye Toward the Future
What makes this a compelling time within EM investments is the degree to which these regions – especially heavyweight China – find themselves on the cutting edge of global trends. One trend we continue to follow is the long-term move toward decarbonization. President Xi Jinping has laid out ambitious plans for China to reach carbon neutrality by 2060. As illustrated in Chart 3, crucial to achieving this objective is the phasing out coal-fired electricity generation. This aggressive timeline will necessitate significant investments in renewable energy and electric vehicles. By many measures, China is at the forefront of developing novel technologies related to decarbonization and deploying them at scale.
The revolution occurring in the energy and automotive industries is having knock-on effects across the global economy. Essential to the drive toward decarbonization is the extraction of metals – among them copper – to help power a battery- and renewable-centric economy. We believe the demand for copper and other essential metals will rise considerably over the coming years, benefiting several EM countries with sizable mineral deposits.
Chart 3: China’s decarbonization programme focuses on replacing coal with renewables
Source: China National Bureau of Statistics, Tsinghua University, JPMorgan. All periods except 2018 are estimates. Data as of 30 April 2021.
We continue to see opportunity in China's technology sector, especially companies tied to the digitization of its economy as this aligns with broad government objectives of increasing productivity and economic growth and helping to mitigate rising social inequalities. Recent developments with respect to more stringent regulation merit close observation, but we believe the central government recognizes the important role played by the tech sector in creating needed services and wringing out efficiencies in the economy. Staying on the right side of these economic and social policy objectives, in our view, will be key to investment returns.
While garnering less attention than technology and energy, EM companies are increasingly contributing to health care innovation. In China as well as other EM countries, the biotech industry finds itself on the right side of official policy as it develops novel therapies to meet patient needs and lower costs. These developments are important in both countries with aging demographics and regions that historically haven’t had access to adequate health care.
Tailwinds, Yes, but a Hand on Rudder still Needed
As with other regions, we believe the economic and social upheaval brought on by the COVID-19 pandemic has accelerated many existing trends, including the digitization of the global economy. In this respect, the opportunity to gain access to value-added technologies and intellectual property within EM economies has never been greater. But given the challenges certain countries face in containing the pandemic while also managing tenuous fiscal positions, risks remain. This potentially divergent path of EM countries means that as the global economy emerges from the pandemic, investors will be tested to identify the most durable trends and innovative companies while also recognizing which countries and industries face secular headwinds and should thus be avoided.
1MSCI Emerging Markets Index℠ reflects the equity market performance of emerging markets.