For the first time in almost 30 years, NASDAQ, S&P 500, and the MSCI indices all posted their record highs on the same day. This got investors incredibly happy, with the stock market rally ushering a sense of freshness with attractive value propositions and prospects of a global growth rebound.
Emerging market equities started on a positive note in 2021, rising by over 30% following the US elections. With an emphasis on economic recovery, markets including China, Brazil, South Korea, India, etc., are set to benefit the most from this healing process.
That said, a market correction in mid-February derailed the momentum, leading to people speculating about the long-term prospects of this market.
Let’s take a look at the key catalysts that will affect the emerging markets sourcing and interpret risks and opportunities to capture the risk-adjusted returns.
Trends in the Emerging Markets Equity
2020 saw the MSCI Emerging Markets Index outperform the S&P index for the first time in 4 years, a trend that it carried well into 2021. In April this year, the International Monetary Fund (IMF) raised the growth projection of EMs by 0.4% from its January forecast, showing the optimism surrounding the growth trajectory of these 27 EM countries.
• Response to the Pandemic
The pace of recovery in these markets, however, has been uneven at best.
Asian countries, particularly China, Korea, and Taiwan, remain at the pole position to lead the EM complex. They have swiftly recovered from the initial outbreak and taken control of the economic downturn, despite further lockdowns to control the spread of the virus.In fact, China and Taiwan were among the countries that delivered positive real GDP growth last year.
Speaking of which, the COVID virus is not the only element playing a role in the recovery of EM economies.
Rising commodity prices bolster the performance of the firms involved in exporting, helping reduce the fiscal deficit in these countries. In addition, prospects for global growth and overseas demand will directly boost the manufacturing and commodities sectors.
• Uneven Recovery
While developed countries resorted to economic stimuli, EM governments have been restrained to an extent. That said, all 27 emerging markets are expected to deliver positive real GDP growth for the first time in over a decade.
On the other hand, India and Latin America endured brutal second waves that overwhelmed the healthcare systems in these countries. While there is still a demand for emerging markets sourcing from these countries, further lockdowns instituted to control further outbreaks will continue to disrupt normal production.
Moreover, falling demand and lack of discretionary spending are helping inflation spread, whereas lesser import is improving the account balances in some countries. As such, it can be predicted that the economic stimuli will remain supportive of the exporting economies from now on.
• Supply Chain Linkages
Business activities improving in the developed countries is shaping up to be another catalyst for economic growth in EM countries.
The spending in these developed markets should directly translate to a dramatic increase in the demand for commodities like steel, copper, and cement. Furthermore, a boost to the emerging market sourcing of goods can be predicted due to the remote working environment and development of industry 4.0 technologies, including 5G, AI, automation, and data centres.
Nowadays, emerging markets are more domestically oriented with next to no reliance on commodities, driving the historical average downside. However, current valuations on a sector-adjusted basis appear too attractive to ignore. The impact on commodity heavy industries will likely play out in the coming months, helping develop a supportive environment for recovering the dip in earnings seen throughout the last two years.
• Interpreting the Key Risks to the Growth of EM Equities
While the GDP of emerging economies is set for a positive growth trajectory, the market correction mentioned earlier has been raising doubts about the long-term growth prospects.
A deeper analysis of the February market correction reveals that the main reasons for the sudden halt were weaker EM currencies compared to USD and a weakness observed in Asian tech stocks.
However, since the earnings recovery has remained consistent ever since, it can be safely assumed that the hurdle wasn’t liked to the fundamentals of the underlying assets.
EMs are likely to face the following headwinds on the road to economic recovery.
• The Limited Upside of USD
A strong USD is one of the biggest risks to EM equities at the moment. Recently, the dollar has grown stronger due to the higher real yield and the economic stimulus worth of USD 1.9 trillion by the US President.
In the near future, the dollar is likely to grow stronger even further. That said, the reasons that pushed the currency upwards are all but diminishing, meaning that the upside potential of USD is fairly limited.
Over the long term, it is expected that the USD will go on a downwards trend, which spells a sigh of relief for the EM equities.
• The Asian Tech Weakness is Short Term
The rising US treasury yield directly impacted the Asian tech stocks, which comprise 21% of the MSCI Emerging Markets index. As a result, Chinese tech stocks lost valuation drastically, triggering a sell-off of global growth names, presenting a problematic situation.
Since tech companies are crucial to Asian economic growth in the next decade, the policymakers are likely to be pragmatic about the tech regulation troubles. Moreover, despite a loss in valuation, the fundamentals have remained strong, presenting the expectations of solid earnings as we advance.
Why you Should Stay Interested in Emerging Markets in the Next Decade
The rapid development of the emerging markets presents a unique high-risk, high-reward situation that has caught the eye of several investors.
A young demographic, rapid urbanization, and the increasing household purchasing power mean a better opportunity for these markets to leapfrog the development stages and reduce the earnings gap with developed countries.
In addition, emerging markets sourcing in Asian countries is set to benefit from the launch of the Regional Comprehensive Economic Partnership late last year. On the other hand, regional trade in African countries has also been bolstered by the African Continental Free Trade Area.
All trends point towards an optimistic overview over the long term in the next decade.