Morgan Stanley
  • Thoughts on the Market Podcast
  • Mar 25, 2021

Diverging Emerging Markets

With Andrew Sheets and Daniel Blake


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.

Andrew Sheets: And on this special edition of the podcast, we'll be discussing equity markets across Asia and emerging markets, and how investors can view the regions in light of an ongoing recovery. It's Thursday, March 25th, at 12:00 p.m. in London.

Daniel Blake: And it's 8:00 p.m. here in Hong Kong.

Andrew Sheets: So, Daniel, it's safe to say that emerging market equities have been a pretty popular asset class. We've seen record inflows into exchange traded funds for emerging market equities, and a lot of that positive sentiment to start the year was based around this thesis that the global economy is recovering and emerging markets are very well positioned to benefit from that economic recovery. And yet, you know, it's safe to say that year to date, the road's been a lot rockier. So what do you think has been going on in emerging market equities? And why have you and your team been a little bit more cautious on the outlook than many other investors?

Daniel Blake: So as regular listeners will know, we've been discussing a relatively cautious view on EM. And I would highlight that the concerns we have include the divergence on the policy cycle as China slows its credit and property sectors to manage leverage risks. And we've also started to see several high beta emerging markets starting to hike rates out of the pressure from higher interest rates coming out of the bond markets in the US. And then finally, vaccine timelines are also now clearly lagging behind the US and UK. So what was their relative advantage in terms of North Asia's first in, first out dynamics of covid management is now turning into a relative headwind when it comes to the progress on vaccinations.

Andrew Sheets: So you talk about the importance of the U.S. growth story. And I do think this is a really key debate because, you know, there's one point of view that the U.S. is the world's largest economy and growth looks to be very good this year and that should benefit emerging markets. And there's another view that strong U.S. growth has more detrimental impacts to emerging market opportunities, as you just mentioned. So why do you end up on the more cautious side of that debate in terms of the impact of maybe better than expected U.S. growth?

Daniel Blake: Yeah at this juncture, we end up with the more cautious side, really because of how much was priced in. So valuations left little room for bond yields to adjust to that stronger growth outlook in the US. And so on the one side of EM, the very expensive secular growth stories that have fundamental attractiveness were caught in an extreme valuation position. And so we're seeing an adjustment at that end of the spectrum - which has been quite abrupt. For example, the average company trading above 10 times prior to sales. And there's a lot more of them this cycle than we've seen previously, is down 15% through this correction. And the average company at the bottom end of less than one times price to sales multiple is actually up 5%.

Daniel Blake: And then the second component has been the financing conditions and the policy scope for those higher, better EMs, where their policy space is partly determined by the US. And as the US runs a very heavy stimulus focus, it's reducing policy space for some emerging markets. And so we've seen rate hikes across Brazil, Turkey and Russia that signal the end of an easing cycle in some parts of EM.

Andrew Sheets: When you think about emerging market equities overall, do you think it's more of a low quality value market or a higher quality growth market? And how do you think about those dynamics?

Daniel Blake: We think it's become highly polarized across value and growth. You've got pockets of both and it's left little in between, but it lags on both counts in the quality domain. So it has a tendency to look at quality and growth and see them as the same exposures. We think in emerging markets you've tended to get low quality exposures, but certainly very high secular growth and also deep value on display.

Daniel Blake: And so we think that characteristics really come out in the correction that we've seen in the last month. But we also see that overall that has been dragging down the index. So we think on balance, it's actually more a growth index than a value index, for better or worse.

Andrew Sheets: Let's talk about those better stories. When you look at your areas of coverage, what do you think offers the most attractive investment proposition at the moment?

Daniel Blake: Yes, so I would make a pitch for Japanese equities and developed market Asia more broadly versus emerging markets within our coverage at this point. We simply have more confidence in the domestic reopening profiles in the near term. We've also seen Singapore and Hong Kong really step up their pace of vaccinations and they've got a clear path to international reopening. And we also see more space for fiscal and monetary policy to remain accommodative. That comes with a stronger US dollar alongside high US bond yields and the policy support that we see with this high pressure economy policy in the US. And in contrast to other parts of EM, that tends to be a neutral to positive for markets like Japan.

Daniel Blake: The other traditional EM that we do like is India. So India, we think it has put in place a credible policy reform agenda, even leading into the covid crisis, but has made use of the uncertainty and the abrupt shift in the economy through covid to make cuts to corporate tax rates to reform labor and agricultural markets. We're seeing state owned enterprise privatizations being announced in the recent budget and that being used to fund stimulus and infrastructure spending. So a much more orthodox pitch for international business and really pitching to see more foreign direct investment from multinational corporates that are diversifying supply chains. And our economists and strategists expect manufacturing really to lead the recovery in India.

Daniel Blake: So we are seeing high frequency data picking up strongly. But we are watching, of course, the dynamics on the ground in India, as well as its historic exposure to higher oil prices and a stronger US dollar. But we do think the external positions is in better shape to manage that, and this domestic reform agenda we think has real momentum. So that is the key emerging market we like. Otherwise, we do think Japan is a credible and stronger alternative to emerging markets to play the cyclical strength in the US policy leadership that we've got here.

Andrew Sheets: Daniel, you mentioned that some of the underperformance in emerging markets,  since early February has corresponded to a pretty sharp rise in U.S. interest rates. Now that we've had that big move, if we were to get a pause and stabilization in U.S. interest rates. Do you think that would be enough to create a positive backdrop for emerging market equities, or is it going to take more than that?

Daniel Blake: Yes. So we're sitting on our price targets for December 2021 for emerging markets on average. And so when we look at, the overall index was a pretty muted returns. And part of that is factoring in some stabilization in U.S. interest rates from here. But if we, if we see a pause in yields or a fall in yields that are driven by even more dovish policy than we expect, for example, for central banks, if they push to keep the current pace of QE operating right through into 2022, then we end up with a more dovish policy mix. And that would be very favorable for emerging markets. Or if the Fed was to adopt a yield curve control framework.

Daniel Blake: Now, these are not in our base case. In contrast, we actually see the strength of U.S. growth recovery potentially leading into fears of a faster tightening cycle. In the meantime, what we're advising to clients is to really be quite selective, to look at the relative strength and weakness within emerging markets, to avoid a tendency to simply by the ETFs, if they can take the time to explore the individual opportunities that come through, because there are a number of markets and sectors that do have very compelling earnings recovery stories coming through in 2021 and beyond. And there are opportunities where we're seeing structural reforms take place at the corporate level and at the economic level, for example, in India, where we think there are opportunities.

Daniel Blake: So we think being selective is important from here and opposing bond yields will be important to see. Again, the upside risk on bond yields would be a downside risk for our emerging markets outlook from here. So we do think we need to be mindful of the relative strength of markets to cope with this policy regime shift that we're getting in the U.S..

Daniel Blake: And Andrew, I'd be interested to hear how this view on EM and Asia coverage fits within your cross asset strategy team's perspective on how this cycle looks and where you see the relative opportunity set across asset classes.

Andrew Sheets: Tt's been a key question for investors because we're relatively optimistic on 2021. We've been optimistic, but, you know, we have not expected, broadly speaking, emerging market assets to outperform developed market assets. And I think that has certainly raised some eyebrows because as we were just discussing, I think emerging market assets are often seen as higher beta expressions.

Andrew Sheets: And, related to that is our view that this recession is behaving more like past recessions than I think investors might otherwise appreciate. Yes, it's been very unusual, but many of the same investment strategies apply. And, you know, when we look back through history, emerging market assets are often some of the best things to buy immediately after a recession. You know, emerging market equities bottomed before the S&P 500 in 2001, they bottomed before the S&P 500 in 2008. But then what we also see from that historical data is as the economy progresses, they become less and less attractive on a relative basis.

Andrew Sheets: And so if we think that, this could actually be a quite sharp cycle. We're seeing enormous amounts of fiscal stimulus, enormous amounts of policy support. All of that suggests an economic cycle that could be running much hotter than those that we're used to. And if it's running hotter, it could also run shorter. You know, all that suggests that we might be moving towards more of a mid cycle environment where historically, emerging market equities and credit have just done less well relative to their developed market counterparts.

Andrew Sheets: This is a reason why my colleague Mike Wilson recently closed his preference for small cap equities. It's also related to the shorter cycle view, but it also ties in, I think, somewhat nicely, Daniel, to the relative caution that you and your team are referencing for emerging market stocks.

Andrew Sheets: Daniel, thanks for taking the time to talk.

Daniel Blake: Great speaking with you.

Andrew Sheets: As a reminder, if you enjoy Thoughts on the Market, please take a moment to rate and review us on the Apple Podcasts app. It helps more people find the show. 

Amid a generally conservative outlook for emerging markets, key differentiators are their scope for policy action, pace of vaccine rollout and equity valuations.

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