The overall macro picture of emerging markets (EMs) have improved vastly in recent months. As we enter 2021, the combination of cyclical recovery, weakening US dollar, commodity upcycle and continuation of China’s strong recovery should uplift EMs’ growth. A vaccine approval next year will be a huge catalyst.
Looking ahead, EM equities may see strong performance underpinned by major tailwinds – prolong US dollar weakness and commodity upcycle. These are likely long-term tailwinds, providing a multi-year positive set up for EM equities which is backed by strong inverse correlations.
Given the cyclicality of EM’s corporate earnings, we expect a robust rebound in FY21/22 which is backed by leading indicators such as China’s monetary stimulus and commodity prices. We find consensus’ earnings estimates too conservative and see upwards revision in the next two years, providing the impetus for greater price return from reaction to earnings revision.
Supported by robust double-digit earnings growth projected for the next two years, EM equities (gauged by MSCI EM index), in aggregate, are set to deliver a potential upside of 18 per cent by end-2022, despite the elevated valuation.
EMs have been plagued by numerous challenges in 2020. Undoubtedly, the Covid-19 pandemic played a major role behind the weakness in EM assets. While several economies like Taiwan and South Korea were able to avoid a prolonged outbreak, others like India and Brazil were not as lucky.
With Covid-19 disrupting almost every aspect of our daily lives, the EMs found themselves wedged between a rock and a hard place. Global demand weakened dramatically while domestic demand was crippled by the pandemic. Together with a sudden tightening of US dollar liquidity, investors witnessed a massive sell-off in EM assets in March.
Fortunately, the pain was rather short-lived. Following a drawdown of almost 35 per cent in the first quarter (1Q), EMs have recovered valiantly in 3Q. According to our FSMI EM index, which tracks the aggregate performance of all EM funds on our platform, EM funds are already up by 10.8 per cent this year.
While several uncertainties still persist in the near term, we believe the tide is turning for EMs and are optimistic that 2021 could be the year for EM assets’ outperformance.
At large, the overall macro picture of EMs have improved vastly in recent months where its economic recovery momentum has notably accelerated. Our observation (as discussed in our recent Asia equities update) concludes that Asian EM’s recovery has gained traction in August/September, where we witnessed a broad improvement of economic numbers, many swinging back to expansionary territory.
Other major EM regions such as LATAM and EMEA have also experienced a surge in recovery momentum across September and October, despite their ongoing battle with Covid-19.
In our opinion, underpinning EM’s recent recovery momentum is the strong combination of i) China’s demand recovery, ii) declining Covid-19 cases, iii) the lagged effect of EM stimulus and iv) global monetary easing. With ameliorating fundamentals under the support of these tailwinds, we believe EM’s economy is more resilient than many think it is.
EM funds was hit hard during March but rebounded robustly in 3Q
Cyclical growth rebound in the works
Entering 2021, we opine that the macro conditions and catalysts are prime for a strong growth rebound in EMs. The combination (as explained below) of cyclical recovery, weakening US dollar, possible commodity upcycle and continuation of China’s strong recovery can propel EM’s growth. This should be bolstered by a more stable and ‘friendlier’ trade policy under a Biden administration.
Cyclical recovery – With the global economy likely moving from the trough of the economic cycle to the early stages of expansion, we expect strong winds of cyclical recovery.
Due to EM’s sensitivity to global demand (such as exports-focus, heavy commodity exposure), a cyclical recovery can significantly uplift EM’s growth as evident from historical cycles. EM typically register stellar growth rate of above dive per cent after an economic trough, evident from previous crises.
Meanwhile, a weaker US dollar is broadly positive for EM’s growth as it eases stress from US dollar funding and is supportive for commodities prices.
We expect an upcycle in commodity next year and anticipate higher prices. This in turn is supportive for EMs’ growth as commodity prices often influences fiscal revenue, trade balance, consumption and investment in EMs.
China’s strong recovery – China’s demand is an integral driver of the global industrial cycle (influences commodity demand) and EM exports. We expect China’s robust demand recovery to continue in 2021 for reasons laid out in our recent update on China equities.
The recent slew of vaccine news spell positive for EMs. While major candidates for the Covid-19 vaccines are still under development, the risk-on reaction in reflationary assets have re-affirmed market participants’ optimism on global growth.
In our opinion, a vaccine approval (unless late in 2021) should amplify the cyclical recovery, setting the stage for a synchronised global demand rebound.
EMs will likely be one the largest beneficiaries, given its cyclicality, and may see growth swiftly shifting into top gear. Markets will also likely look pass EM achieving ‘herd immunity’ and the positive impact on EM assets may be significant, particularly EM equities with cyclical and commodity exposure.
We expect a sustain rotation into the aforementioned equity segment in 2021, should a vaccine approval come through.
EM funds, on aggregate, returned 16.3 per cent over a one year period
Commodity upside the other big tailwind for EM
Prolonged years of underinvestment by commodity producers has resulted in delayed supply response. This is evident from a drawdown on commodity inventories (for many sectors) over recent quarters as global demand was revitalised.
In our opinion, this is an uncommon occurrence this early in the economic cycle and may lead to a possible supply shortage, considering potential output cuts planned in 2021 by producers.
We also note that the above is a broad observation in the commodity space, but we see greater elements of it playing out in the metal and oil markets currently.
Transitioning to the demand side, we expect support to come from strong Asia demand as well as the broader global cyclical recovery, which we argue is underway. The recent rally in the industrial metals and oil complex is also implying mounting optimism for global growth.
Entering 2021, we remain aware that demand could receive a push from a potential vaccine and further re-opening of economies.
All things considered, years of weak capex and a burgeoning global cyclical recovery are set pieces for a possible supply-demand mismatch. Coupled with the positive backdrop of a weakening dollar, commodity prices could see further upside in the coming years, acting as tailwinds for EM equities which historically tends to be uplifted by rising commodity prices.
EM’s earnings growth shifting to higher gear, but consensus still conservative
Given the cyclical nature of most EMs, earnings for EM equities (gauged by MSCI EM index) are also subjected to cyclicality and tend to exhibit the periods of large contractions and expansion during cycle downturns and upturns respectively.
We believe it is no different for this cycle and expect a robust rebound in FY21/22. While our EM earnings growth projection for FY20 is closely in line with consensus’ expectation of 16 per cent, our projection for FY21/22’s growth rates differ.
From a sectoral level, we opine that current consensus’ FY21/22 earnings expectation for cyclical sectors are too conservative, especially after accounting for historical revisions and comparing against growth rates during previous crises.
Similar observation can be made for earnings growth estimates at an EM country level. Generally, consensus’ FY21/22 earnings growth rates were also conservative for the most cyclical EM markets (Taiwan, S. Korea and Brazil), which we found contradictory when compared against the massive upwards revision and earnings rebound for these markets after each crises.
Given the conservative estimates by consensus, it is likely that 2021 may see upwards revision in EM’s earnings estimates should our macro outlook for EMs hold. This should provide the impetus for greater price return as market should react positively to these revisions.
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