Emerging Markets Equities Poised for Strong Earnings Rebound
Market insights from Portfolio Manager John Paul Lech
As the economic recovery continues to broaden out, how do you see the emerging markets?
At the moment, one area of concern we have is that valuations have risen across asset classes including emerging market equities. However, there are still many great companies—characterized, in our view, by both their quality and adaptability—across emerging markets where we believe valuations are supported by fundamentals.
In general, emerging markets do well when global demand is rising and when local currencies are strong. There are reasons to believe both of those conditions are present right now. First, the world is coming out of a synchronous slowdown caused by the pandemic and while some geographies may recover faster than others the general direction of travel, in our view, is positive. Second, many large central banks within emerging markets have already started to tighten, which is supportive of currencies. Finally, the specter of higher inflation tends to bode well for commodity prices, which benefit certain geographies. The transient vs. structural nature of inflation can be debated, but aggregate demand appears to be coming back. The investable universe of emerging markets, however, is typically more influenced by tech than commodities. Within both the U.S. and emerging markets, the initial market rebound back in 2020 seemed to emphasize growth at any cost, which has reversed now. In general, we are seeing a rotation favoring concrete growth or more quality growth. It’s healthy that market performance broadens out a bit. In our view, the market favors a flexible approach, not a dogmatic factor-based one.
Where are you seeing opportunities in emerging markets?
The past year has been extremely volatile. Looking back to May 2020, we were in the middle of a global pandemic. At the time, most experts believed we’d get a vaccine eventually with probably 50-60% efficacy and no one knew when vaccines might be available. By November, we had several options with higher efficacy, which is remarkable. We saw pronounced changes to consumption patterns, the acceleration of existing trends and a sea of liquidity unleashed by central banks and government policy makers. It remains to be seen how lasting everything is in the next normal. There have been false starts to reopening but emergence to the next normal seems increasingly likely. As we’ve gotten closer to whatever that next normal is, we’ve widened our approach which has led us to themes like tourism or real estate which complement some of the themes that have been present in our portfolio throughout, like e-commerce.
We are looking for companies that can adapt and thrive across a broad range of conditions, so our approach to identifying good companies has remained consistent. There are five key attributes of companies that we generally like. We call these the “Five Cs”—competitive position, capital allocation, capital structure, cash flow and character. These attributes help us determine whether the business is being run appropriately for the long term, including for shareholders like ourselves who are not in a control position. The year 2020 taught us that things can change in ways that aren't easily forecasted or perceived, and underscored the importance of the quality of companies’ business models and management teams. So our focus is really on quality companies who are capable of managing the volatility that is inherent in emerging markets economies.
In looking at our investment universe, we have asked ourselves which companies would either benefit or see their business not disproportionately impacted by the global pandemic. That led us to a few sectors where we saw natural acceleration in the businesses—e-commerce, for instance, or certain software providers. The key now is to sort those companies into the ones whose competitive advantage was changed in a catalytic, structural sense versus those who saw a transitory increase in revenues.
What is your outlook for emerging markets?
We believe 2021’s recovery in asset prices will continue to favor emerging markets and Asia and that the fierce rotation into cyclically oriented names will slow substantially in coming months. The surge of U.S. Treasury rates was largely fueled by news of potential U.S. stimulus, surging commodities (metals and oil) and fears of inflation. I expect the across-the-board increase in commodities may abate as supply pressures ease. The pace of U.S. Treasury rate increases should slow substantially, in our view. We do not expect that large developed market central banks will hike policy rates in a meaningful fashion, leaving only select emerging market central banks to increase rates, such as Turkey and Brazil. Therefore, as inflation fears dampen in the second half of 2021 and U.S. rates stabilize, we expect Asian and emerging markets risk assets to revert back to fundamentals, reflecting a strong earnings rebound expected in the 2021-22 period, allowing for growth stocks perform well and cyclical stocks to separate into those who deserve to climb more and those who don’t have structural fundamentals.