Andrew Sheets: Welcome to Thoughts on the Market. I'm Andrew Sheets, Chief Cross-Asset Strategist for Morgan Stanley.
Daniel Blake: And I'm Daniel Blake, Equity Strategist covering Asia and emerging markets.
Sheets: And on this special edition of the podcast, we'll be discussing the 2021 outlook for equity markets across Asia and how investors can view the region amid a global recovery. It's Tuesday, December 15th, at 12:00 p.m. in London.
Blake: And it's 8:00 p.m. in Hong Kong.
Sheets: So, Daniel, I want to actually start with what were the lessons that you take away from the performance of Asian EM equities in 2020?
Blake: Yeah, it certainly has been a dramatic year for emerging markets in many regards. There has been substantial hardship and some economies have only just started a recovery while COVID case numbers are accelerating in many countries. So we're really not through the pandemic just yet. And at the same time, amidst the deepest recession since World War II, we actually haven't seen some of the worst fears play out with regards to potential debt or currency crises for emerging markets. So much of this, we think, can be put down to the extraordinary global policy response and a relatively good starting point in terms of inflation and foreign debt levels for EMs, which allow them to benefit from the stimulus unleashed in the US and Europe, while themselves adopting record low interest rates. One of the new precedents we've seen this year has been that in some emerging markets, we've even seen quantitative easing policies being adopted by central banks, where they’re buying their own government's debt. And at this stage, investors have been giving them the benefit of the doubt in terms of their willingness and ability to stop unconventional policy when inflation returns.
Blake: So all up, we're seeing the aggregate MSCI EM benchmark up 12% year-to-date as of the 10th of December, and that's taken the market even above our 2020 forecasts that were made before COVID and the pandemic.
Sheets: So, Daniel, now looking ahead at a broad level, what are you expecting for emerging market equities to return next year?
Blake: Yeah, when we originally made the forecast for the 2021 outlooks in mid-November, we were looking for high single digit upside. But we've actually seen all of that priced in already. And so we're sitting right at our target prices for December 2021, which leads us to think we need to be a little bit careful around tactically what is priced in. But we do think positioning within the asset class and within markets is going to be important for investors. We often see a temptation in markets, particularly EM, to play a mean reversion trade, maybe not selling all of the winners, but certainly to looking to buy the laggards. But we think in the wake of what we've seen from the COVID-19 pandemic and the policy response, the structural change in the economy, that investors should be very careful on that front, simply buying the laggards and really take the time to work through what we think are four crucial structural themes.
Blake: So we think they are changes in the nature of work and consumption post-COVID. The rise of ESG and the importance of ESG and the transition to a net zero global economy by the mid 21st century. The accelerating technological disruption, what that means for markets and more importantly, I think the emerging regulatory response to that. And then finally, we've seen U.S.-China tensions, but we put that in the context of a global transition to a much more multipolar world.
Sheets:What are the companies that would be potential beneficiaries or losers from this shift to a multipolar world?
Blake: We see two categories of companies. One is what we call slowbalizers, and that picks up on a Dutch academic term. And it's capturing the fact that we're seeing this slow motion unwind of globalization in some segments, we think. And that is particularly in areas where our processes technology is quite sensitive to national security and where either supply chains or end markets cross these polls in the global economy and those we see being faced with challenges in terms of managing the political and regulatory pressures that they face.
Blake: Then on the flip side, we've got emerging regional champions. Now they are companies that also see some sensitivity around the use of data, for example, but they also may benefit from increasingly protected domestic or regional markets, given the sensitivity around foreign competitors not being allowed in or seeing greater regulatory protections around their business models. So emerging regional champions, we see ultimately being better positioned.
Sheets: In a lot of my conversations around emerging markets for the year ahead, caution is not the word that investors use. They're very optimistic about emerging markets. They see this as the perfect place to be if the global economy is recovering, if the dollar is weakening.
Sheets: So, Daniel, I wanted to talk to you a little bit more about why you think that's a little bit too optimistic as a way to think about emerging markets for next year and why you do think that investors should remain disciplined in setting these price targets?
Blake: Ultimately, it does come down to the extent of policy space we see for emerging markets and also the transition that we're expecting in policy from a number of key emerging markets next year. So we are seeing China take its first steps towards exiting stimulatory policies with the PBOC making more direct statements around needing to take a more measured pace of credit growth next year. So with China being first in, first out of the pandemic itself and ultimately likely to be one of the first to withdraw stimulus, that has implications for exporters to China. We also see the policy scope, after a significant rise in leverage, it will be emerging markets we think that are more called into question first in terms of how they have a exit, extraordinary policy support and where we see corporates themselves needing to make sure they're on a solid footing when it comes to liquidity and cash flow position.
Sheets: Well, I'm glad you mentioned China, because I do think that's a pretty kind of fascinating way to think about the year ahead, that that China was kind of first into this global recession. It very well might be the first out, and because it's first out, its policy might turn around and get more restrictive from a central bank standpoint than other places. So I just want to touch on that a little bit more, especially given how big China is as part of the emerging markets. What is your team's view at the moment for China equities?
Blake: So we have seen China taking an increasingly dominant role in the broad emerging market equity complex. So it's weight within the benchmarks has moved up to around 30%. But when we look at the correlation with the broad EM benchmark is heading north of 80%. So it doesn't explain all of their returns, but it is a dominant driver of returns. And the policy cycle within China is something that is key for us. We think the equity markets and the policy are set up. It may be the first to withdraw policy support after a significant rise in debt levels through 2020. We've also seen the government recently adopt a net zero target for 2060. That's where we focus investor attention on the renewables supply chain, the EV supply chain. We've also seen important regulatory steps taken for the fast growing digital economy. And at the same time, we're seeing measures taken to better insulate China's tech ecosystem from U.S. export controls in this transition to a more multipolar world.
Blake: When we weigh that up with the outlook for policy, we do think it is ultimately going to be a constructive year for China equities in 2021 even after the outperformance this year. We see the positive structural opportunities outweighing the policy transition and we see that policy transition so far being countercyclical. In other words, it's taking away some of the stimulus as the US, Europe and other export markets are picking up. But it is a transition we'll need to keep a close eye on.
Sheets: Daniel I also think when talking about emerging markets and Asia equities we can't avoid these questions of geopolitics. We've got a new incoming U.S. administration. How do you think that will affect the investment case for emerging market equities?
Blake: Yeah, we've looked at this theme in the context of what we see as a transition to a more multipolar world. So the U.S., China tensions are really just part of this broader trend that we're seeing. The U.S. and China are increasingly on a competitive footing across multiple fronts. So we're not expecting any return to broad engagement on that front. When we're looking at this in the context of emerging markets, we think it's important to bear in mind that other major economies, Europe, Japan, the rest of Asia, are all looking to see how this relationship unfolds and looking to seek their own influence and economic opportunities as part of this theme. We think there will be a real focus on a return towards a more multilateral posture and engagement, maybe some more predictability. But at the same time, we don't expect any major reprieve in some of the longer-term uncertainty in the competition around the development of standards, for example, in the tech sphere. And the increasing concerns around dual use technologies, and so this will be a long lasting thing for investors to bear in mind.
Sheets: So, Daniel, you know, a topic that we discuss a lot is this idea that EM is often a label of convenience for these markets, that the underlying markets that you're investing in within emerging market equities are very different in terms of the development level of the economy, the make up of the local equity market, kind of it's factor exposure. So you as you drill down within the emerging market index, what are some of your favorite markets for the year ahead, and where are markets where you're more cautious?
Blake: Yeah, that's right. So it is a highly disparate set of opportunities across emerging markets and much of that reflects the composition of sectors. So some markets are heavily weighted towards financials and energy. Others are much more skewed towards tech. And for example, we see the Taiwan index being dominated by tech. Korea similarly, a heavy tech exposure as it relates to the sector contribution that makes the biggest factor when it comes to remerging markets and the differentiation between them. So when we take into account the structural themes, the outlook for the recovery, we do see North Asia still being relatively well positioned in the post pandemic era, even after its outperformance this year. So we do like Korea, we like China. We've upgraded MSCI Hong Kong to overweight. At the same time, we see Australia being positioned to benefit from a sustainable reopening, having brought the pandemic back under control and positioned for this domestic reopening with the economy, benefiting from additional stimulus on a fiscal and monetary basis. So that that's some of our key overweights. In terms of a cyclical recovery, we also like Brazil, which we've held an overweight to. We see that benefiting from the commodities reflation. We've held Greece overweight in our 2021 outlook. So we see that benefiting from increasing sight of the European Recovery Fund, the stimulus across Europe.
Blake: And then finally, with upgraded India to overweight. In India, we see having made a more structural progress on reform than a lot of investors recognized through the pandemic. It suffered from a deep recession, no doubt, but we think the exit for India may see it benefit from increasing structural trends, including supply chain diversification out of China in this transition to a more multipolar world. And so that manufacturing led growth that we expect to come out of the pandemic, we think will benefit India equities. And so they are the key markets that we like for 2021.
Sheets: Daniel, thanks for taking the time to talk.
Blake: Great speaking with you Andrew.
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