- The overall macro picture of EMs have improved vastly in recent months. As we enter 2021, the combination of i) cyclical recovery, ii) weakening USD, iii) commodity upcycle and iv) continuation of China’s strong recovery should uplift EM’s 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% by end-2022, despite the elevated valuation. Our EM top picks - China, S. Korea, Taiwan, Indonesia, Brazil.
Emerging markets (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 USD 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% in Q1, EMs have recovered valiantly in Q3 2020. 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% 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.
Chart 1.1: EM funds (blue line) was hit hard during March but rebounded robustly in 3Q
Chart 1.2: EM funds, on aggregate, returned 16.3% over a one year period.
Source: iFAST Compilations.
Data as of November 2020.
EM’s economic recovery gathering steam
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. A look at table 1, shows the manufacturing PMI (often a leading indicator for economic activity) rebounding firmly since August for most EMs.
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.
Table 1: Valiantly recovery in Major EM’s PMIs since Aug, broad-based swing to expansionary territory
Source: Bloomberg Finance L.P., iFAST Compilations.
Data as of November 2020.
Chart 2: Rebound in economic activity in EMs (ex China) has surpassed DMs
Source: Topdown Charts (topdowncharts.com), Refinitiv Datastream, Markit.
Data as of October 2020.
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 USD, 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 (i.e. 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 5% after an economic trough, evident from previous crises (chart 3).
Weakening USD – As explain in the section below, a weaker USD is broadly positive for EM’s growth as it i) eases stress from USD funding and ii) is supportive for commodities prices.
Positive commodity outlook – As explain in the section below, we expect an upcycle in commodity next year and anticipate higher prices. This in turn is supportive for EM’s 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 i) the global industrial cycle (influences commodity demand) and ii) EM exports. We expect China’s robust demand recovery to continue in 2021 for reasons laid out in our recent update on China equities.
Chart 3: EM’s GDP has always seen strong cyclical recovery after crisis
Covid-19 vaccine will be a major catalyst for EMs
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.
USD weakness a big tailwind for EM equity outperformance
Historically, the dollar traverse in long-term cycles (Chart 4) where the bull and bear trend can lasts anywhere between 6 to 7 years. In our opinion, the dollar’s protracted weakness over recent months, after appreciating around 35% since 2013/14, is a possible signal that we might be in the initial phase of the dollar down-cycle,
Looking ahead, we see continued dollar weakness, especially against EM currencies. The wide interest rate differentials (especially between EM and the US) and possibly greater ‘money printing’ by the Federal Reserve (to finance more government spending under a Biden administration) are strong near-term headwinds for the greenback.
At the same time, a structural US current account deficit coupled with an expected EM economic growth outperformance (USD tends to decline if growth of rest-of-the world outpaces US) also set up the prospects for a longer-term dollar weakness vis-à-vis EM currencies.
Most importantly, the dollar weakness bodes well for EM assets. There are two key reasons why the EMs benefits from a weaker dollar. Firstly, it alleviates EM’s USD debt repayment stress and default risks, which can be significant headwinds for EM equities. Secondly, dollar weakness tends to support commodity prices, which are largely priced in the greenback. This is positive for EM equities due to their high commodity exposure.
With a possible multi-year dollar down-cycle in the works, we expect stronger and longer-term support for EM equities, which is backed by strong inverse correlations between the dollar’s strength and EM equity prices across history (chart 5).
Chart 4: The USD possibly headed for a multi-year downcycle
Chart 5: Strong inverse correlations between USD strength and EM equities price
Commodity upside the other big tailwind for EM equity outperformance
Prolonged years of underinvestment (CAPEX for most commodity sector broadly declined since 2012 despite a brief upturn in 2017) 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 revitalized.
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 (chart 6).
Chart 6: Strong inverse correlations between USD and commodity prices
EM’s earnings growth shifting to a 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%, 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 (Such as Con. Disc., Financials, Real estate) are too conservative (Table 2), 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) (Table 3), which we found contradictory when compared against the massive upwards revision and earnings rebound for these markets after each crises.
We believe the conservative earnings estimates warrants an adjustment, backed by our constructive macro outlook for EM, and we project EM earnings to grow robustly by 36.4% (FY21) and 21.9% (FY22) from a bottom-up estimate.
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.
Table 2: Consensus estimate of EM’s sectoral earnings growth for FY21/22 are too conservative
Source: Bloomberg Finance L.P., iFAST Compilations.
Data as of November 2020.
Table 3: Consensus estimate of individual EM’s earnings growth for FY21/22 are also too conservative
Source: Bloomberg Finance L.P., iFAST Compilations.
Data as of November 2020.
Chart 7: Earnings growth forecast for EM equities
Leading indicators pointing to strong earnings rebound ahead
Our constructive view on EM equities’ FY21/22 earnings is reinforced by a combination of leading indicators – constructive growth backdrop, China’s monetary stimulus and upside in commodity prices, which are suggesting robust earnings growth in FY21/22.
In particular, China’s stimulus (proxied by monetary supply growth) has always shown strong correlation with EM corporate’s earnings. Such is the result of China’s domestic demand, heavily influenced by stimulus measures, being an integral driver for EM goods and commodities. As seen from chart 8, recent monetary supply injection is pointing to higher earnings growth over the next 12 months.
Upside in commodity prices also bears strong correlation to EM earnings growth. With EM’s high exposure to commodity, fluctuation in its prices tend to influence margins for EM corporates rather quickly. As seen from chart 9, the recent rally in commodity prices is implying higher earnings growth over the next quarter.
Chart 8: China’s stimulus has strong correlation with EM’s earnings and points to higher growth next year
Chart 9: China’s stimulus has strong correlation with EM’s earnings and points to higher growth in the next quarter
Headwinds and risks for EM equities
With the recent Biden presidential victory coupled with a barrage of positive vaccine news, EM assets in general has rallied significantly as of late. This has engendered a strong wave of re-rating across valuation multiples for EM equities, elevating it to heady levels as earnings revision has yet to catch up.
Valuation level (as measured by forward PE ratio) for EM equities, in aggregate, are trading fairly above historical mean for both forward Y and Y+1 estimated earnings, as shown in chart 10. Current levels are also above our fair PE ratio of 13.5X which is signaling some froth in EM equities’ valuation, elevating the risk of de-rating in the near term.
Yet, this is a minor risk in our view as i) EM equities’ forward PE ratio (Y+1 EPS) is only marginally above our fair PE of 13.5X and ii) we believe many will view a de-rating as dip buying opportunity given mounting risk-on appetite for EM equities. Especially from a longer-term basis, we do not view current valuation overly tainting the shine on EM equities. For investors looking for value in EM markets, Brazil and Indonesia are still relatively cheap to us.
The pandemic presents itself as a primary ongoing risk for EMs. A severe resurgence in cases, be it within EMs or DMs, will spell bad news for a cyclical recovery and a delay in vaccine approval in this scenario could magnify the impact.
While this scenario has faded behind the volley of positive vaccine news, it remains the key risk to watch for EM equities. Nevertheless, given the uncertainty in Covid-19 cases, it is hard to ascertain the likelihood of the above scenario and thus, does not derail our outlook for EMs significantly.
Chart 10: Valuation of EM equities have gotten frothy lately
EM equities to take the lead in 2021
There is much headroom for EM outperformance in 2021 in our opinion. Supported by robust double-digit earnings growth projected for the next two years, EM equities (as gauged from MSCI EM index) are set to deliver a potential upside of 18% by end-2022, despite their elevated valuation now.
Within EMs, we believe Asia EM equities should lead outperformance early in FY21. It offers a better risk-reward profile, especially for cyclical Asian EM markets, and those that has yet to catch up. LATAM and EMEA equities should offer greater upside potential in FY21 but at the cost of higher risks embedded as fundamentals lacked its Asian peers. We note, however, that a vaccine approval should alleviate much risk for these two regions.
Overall, our EM top picks are China, S. Korea, Taiwan, Indonesia, Brazil (table 5).
Looking ahead, we believe a heady cocktail of positive catalysts are aligning for the EMs. The combination of a cyclical recovery, dollar weakness, upside in commodity prices and robust earnings rebound are forces that are hard to ignore. The last time we observed such an alignment of favorable fundamental and macro conditions was after the 2008 GFC – more than a decade ago.
In addition, the potential of a successful vaccine in 2021 – given the massive push globally – may amplify the tailwinds mentioned above. All things considered, we believe the tide is turing for EMs and 2021 could be their year.
Chart 11: EM equities anchored by strong expected earnings rebound in FY21/22
Table 4: Forecasts for MSCI EM index
|
Emerging Market (MSCI EM Index) |
FY2019 |
FY2020 |
FY2021 |
FY2022 |
|
PE ratio (X) |
15.3 |
19.0 |
13.9 |
11.4 |
|
Expected earnings growth (YoY %) |
-13.0% |
-16.0% |
36.4% |
21.9% |
|
Earnings Per Share (EPS) |
72.8 |
64.5 |
87.9 |
107.2 |
|
Projected fair price (Based on 13.5X fair PE ratio) |
|
- |
- |
1447 |
|
Potential upside (%) |
- |
- |
- |
18% |
|
Source: Bloomberg Finance L.P., iFAST estimates. Data as of 25 Nov 2020. |
||||
Table 5: 2021 views on our EM top picks
|
EM equity |
Rationale |
China |
|
S. Korea |
|
Taiwan |
|
Indonesia |
|
Brazil |
|
Table 6: Product for EM markets
|
Market |
Actively Managed Funds |
ETF |
Emerging Market | Fidelity Emerging Markets Focus A-USD | |
China |
||
S. Korea |
||
Taiwan |
||
Indonesia |
||
Brazil |
The Research Team is part of iFAST Financial Pte Ltd.
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