The biggest lesson from 2021 in emerging market equities is that the universe as defined by indices such as MSCI EM masks enormous dispersion in performance among its constituents.
The best example of this is Korea and India, two markets which each occupy about a 12% weight, fundamentally have very little in common (per capita income in Korea is almost 20x that of India), and witnessed an almost 35 percentage point divergence in returns in 2021.
References to EM as a single asset class, which are all too common, eg "EM has underperformed DM", should be treated with suspicion. Country, sector, and stock selection within EM matter a lot and passively managed ETFs, which simply mimic the index, are not the answer.
The current global backdrop suits country markets which are:
externally robust in terms of currency and external debt risk (or at least are already pricing in any vulnerability).
are on top of, or are getting on top of, inflationary pressure.
have equity valuations that are cheap relative to history.
offer exposure to one or more of manufacturing exports, commodities, tourism and technology.
The Covid era of stuttering and uneven growth persists, which means all of these sectoral exposures, at an attractive price, should have a place in an EM portfolio.
We are not in the sort of unidimensional world which would favour one sector so much more clearly than another over the course of an entire year. We are not in the environment of high global growth (or complete lockdown), zero interest rates and unending quantitative easing in developed markets, plentiful monetary and fiscal policy stimulus across EM, a commodities super-cycle driven by unending Chinese infrastructure expansion, or a rapid wholesale shift of global manufacturing out of China to other parts of EM or back onshore to developed markets.
Examples of EM pockets that reflect these views, each with its own associated risks of course, are as follows:
China tech, Brazil, Mexico and Thailand in larger EM.
Chile, Egypt, Indonesia, Pakistan and Vietnam in smaller EM.
Below is our summary of the year just gone, the lesson to be learnt from it, and our equity strategy view as we start this year.
The optimistic EM thesis in January 2021
At the start of 2021, emerging market equity investors were hopeful. Consensus expectations were for a supportive combination of the following:
Low global interest rates and yields, and a flat to weaker US Dollar (which would both alleviate pressure on EM currencies and fuel the appetite of local investors to switch out of low-yielding bank deposits and local currency government bonds into local equities).
Reflation from a combination of post-Covid normalisation and a bumper (infrastructure-focused) fiscal stimulus package in the US (leading to strengthening commodity prices for exporters but to a degree that was manageable for importers).
De-escalation of geopolitical friction between the US and China, the resurrection of the Iran Nuclear Deal (with an implied dampening of oil prices), and maintenance of the status quo with Russia under the new Biden administration.
EM equities ex-Tech, particularly in smaller EM, offered cheap valuations relative to US equities.
The main risk to this outlook was a major resurgence of Covid infection and disruption.
What went wrong with this thesis?
Covid did not dissipate quickly because of new variants (Delta and Omicron), overwhelming even the previously successful track, trace, and lockdown strategies seen in Asia, and, for much of the year, because of lagging vaccination rates in EM (which still persist in Sub Sahara Africa).
Benign reflation hope turned into lasting inflation concern, because of supply chain disruption, labour shortages, and commodity price strength, in turn, due to a combination of years of under-investment (particularly crude oil). The US Fed finally turned more hawkish, with Chair Powell jettisoning the word "transitory" towards the end of the year, starting the tapering of asset purchases, and signaling impending rate hikes.
Commodity prices rallied to such an extent that countries reliant on, particularly, fuel and food imports suffered from imported inflation, widening current account deficits, fiscal burden (where there are subsidies), and social and political unrest, all at a time when they were trying to normalise economic policy stimulus enacted after the Covid disruption, particularly fiscal deficit reduction. It is no surprise that many EM countries have started tightening monetary and fiscal policy well before the US.
The EM investment case, for those who paint the entire opportunity set with one brush, was superseded by the narrative of TINA – "there is no alternative to [US] equities", given a superior growth outlook in the US compared to much of the rest of the world, in turn, largely because of its exceptional ability to pursue ongoing stimulus without crashing its currency.
US foreign policy under Biden has been more predictable than under Trump, but no more helpful from an EM investor's perspective.
US and China relations have remained as frosty under Biden as they were under Trump (indeed this remains the one issue over which there is bipartisan consensus in the US Congress). Trade restrictions have not changed and tensions over, for example, Taiwan are even more fraught.
Tensions with Russia, after encouraging signs around the NordStream2 gas pipeline sanctions waiver and the Biden-Putin summit, ultimately significantly deteriorated over the issue of Ukraine.
The abrupt and chaotic withdrawal of US forces from Afghanistan reinforced the concern of partners and allies of the US in GCC, ASEAN and India regarding the precedent that it sets for US commitment to their security.
The Iran Nuclear Deal has not been revived and the election of hardline President Raisi may make this even less likely.
In addition to this, three other factors, outside the terms of the original thesis, worked against the broad EM asset class.
Fund flows into the EM equity asset class bifurcated between relentless inflow for China and India, irrespective of setbacks in the fundamental stories of both, and a foreign abandonment of almost every other part of EM.
In part, this is driven by the view that the share of the global economy that these countries represent are far greater than their current share of benchmark global, not merely EM, equity indices.
Also, this bias in foreign fund flows may be reflective of the dominance in marginal new allocations of passive over active funds in EM.
Domestic politics took an investor-unfriendly turn in the biggest EM countries and regional blocs, specifically:
China — President Xi's shift from raw growth to "common prosperity", driven as much by the imperative to preserve the Communist Party's monopoly on political power as the need to address inequality, but derailing, in the short-term at least, the Tech and Real Estate sectors in the process.
India — President Modi having to retract one of his main reforms, the Farmers' Laws.
Brazil — President Bolsonaro responding to the erosion of his support base from the mismanagement of Covid with a populist shift in fiscal policy.
South Africa — massive unemployment and the divisions between the President Ramaphosa and former President Zuma camps of the ruling ANC party, inhibiting any meaningful reform actions.
LatAm — for much of the year, it appeared that the political pendulum was swinging leftward, although it is more accurate to describe the electoral transitions as rejections of the status quo, eg in Q4 the right-leaning Peronist government of Argentina suffered a major setback in its mid-terms.
Brazil — the legal and political resurrection of former President Lula, who has enjoyed a large opinion poll lead over incumbent Bolsonaro.
Chile — the election of a constitutional reform body where left-leaning politicians were the largest single grouping and the leftist victory in the presidential election of Gabriel Boric.
Colombia — the loss of opinion poll support of right-of-centre candidates following the anti-corruption investigation of former President Uribe and the underperformance of the current administration, led by his acolyte, President Duque.
Mexico — the leftist alliance of President Lopez Obrador retained their majority in the legislative elections, albeit by less than the two-thirds required to push through constitutional change.
Peru — the election of far-left President Castillo.
In Turkey (a small index weight but close to a top-5 EM by value traded), orthodox interest rate policy was again turned on its head in the second half of the year, adding it to the list EMs with truly dysfunctional economic policy — until then comprised only of very small and marginal Frontier markets (Argentina, Lebanon, Nigeria, Sri Lanka, Venezuela).
Lesson for 2022: EM not homogenous, big dispersion in performance
Categorising all of EM as one asset class does not make fundamental sense. An affluent, industrialised economy like Korea, with GDP per capita of US$37k, has very little in common with India, with GDP per capita of US$2k.
And getting exposure to EM via a passive fund, which mimics the indices provided by MSCI or FTSE, misses all the dispersion in performance driven by those fundamental differences; both Korea and India have about a 12% weight in MSCI EM, but Korea was down about 10% in 2021, in total US$ return terms, while India was up about 25%.
The common comparison of the performance of the MSCI EM index (down 2% in 2021) versus, for example, MSCI DM (up 22%) completely misses the point of the investment exercise in EM — picking countries, sectors, and stocks for alpha generation. Relatively high real GDP growth expectations for the US in 2022, over 5% according to the IMF, tends, erroneously, to reinforce this tendency to treat all of EM as one.
This is not to belittle the impact of global factors, specifically conditions in the US and China, on all EM, because of the interconnected nature of global growth and global funds flows.
These include the macro outlook for the US (inflation, rates, and the dollar, which sets the risk appetite for anything outside the US and DM), the valuation and regulatory risk that investors will tolerate in US equities – specifically in Mega Tech (where equity returns have been so great that they have crowded out any serious reallocation of assets to EM ex-China), and the comfort of governments in source tourist markets like the US (and elsewhere in DM) to allow their citizens to travel with few restrictions.
China remains key as well: for much of ASEAN (where manufacturing supply chains are linked with China even as they aspire to grab market share from China) and the commodity exporter subset of EM (where China remains the largest single customer). Covid disruption in China ripples into ASEAN manufacturing and macroeconomic deceleration in China overwhelmed hard commodity prices in iron ore and copper in 2021.
But these repercussions do not hit EM evenly, hence the wide dispersion of performance under the hood of the index.
The 2022 global backdrop looks like its it going to feature, with some hiccups along the way, the following:
Stable to higher oil and commodity prices (as global growth remains positive and the legacy of under-investment in commodity extraction persists).
Dissipating Covid disruption (higher levels of vaccination and prior infection, prior deaths of the most vulnerable, less fatal variants, and intolerance of further lockdowns).
Flat to down US dollar (as global growth normalises but US rates and yields slowly move up).
Except for China, much less room for policy stimulus in emerging markets (as Covid-era fiscal deficits are narrowed and interest rates are hiked to cope with higher inflation).
Pressure on local investor flows in those EMs where local interest rates and bond yields are slowly moving up.
All of this adds up to a continuation of uneven, stuttering growth across EM, and a greater emphasis on country, sector, and stock selection.
A mix of cheap tech, commodities, tourism, manufacturing and reform
China Technology (particularly Alibaba and Tencent) is among the cheapest and most liquid exposure to structural growth, which has benefited, of course, from Covid-19 disruption but will outlast it, albeit the entire sector now has to conform to the diktats of the one-party state (which is what their de-rated valuations already reflect).
State interference and tougher regulation in publicly-listed tech is only now becoming more prominent, and may not yet have run its course in other markets, eg Russia Tech.
While tech adoption cycles (with 5G and the metaverse next round the block) still favour pricing for most of Korea-Taiwan tech hardware (also helped by the semiconductor shortage) and Indian IT services, valuation already reflects this. For Taiwan and TSMC in particular, there is arguably no reflection of China conflict risk.
In small EM, where scarce tech exposure has driven premium valuations, among the most liquid plays, Mercado Libre is looking cheaper relative to its history than Sea.
Commodity exporters, particularly those not at significant valuation premia versus history, offer exposure to the recovery in global growth. These are found mainly in LatAm: Brazil in large EM in iron ore and agriculture exports, Colombia in oil, and Chile and Peru in copper. All of these have de-rated on concern over a leftward shift in government, even though many of their current problems were not addressed under the current or preceding right-leaning governments.
South Africa is also cheap relative to its history, arguably reflecting what are now well-understood risks around ruling ANC party division, vested interest blocking structural reform, and chronic social inequality and youth unemployment.
Russia and Saudi clearly have an oil price tailwind in their favour, but Russia is marred by geopolitical risk (conflict in Ukraine and additional US sanctions) and Saudi is expensive relative to history.
Tourist destinations like Thailand in large EM, and others at attractive valuation versus history in small EM, like Croatia, Egypt, Georgia, Greece, Mauritius and the Philippines, offer exposure to the release of pent-up demand after Covid disruption.
Other tourist markets which are recovering, but where equity valuations have already positively re-rated, include Dubai and Iceland.
Alternative manufacturing locations to China that should benefit from US-China friction – Bangladesh, Malaysia, Mexico and Vietnam – are reasonably valued compared to history.
Structural reform (self-help) is a slow and stop-start process, but despite the Covid shock and domestic political challenges this continues in at least two markets that are cheap relative to history, Indonesia and, more so, Pakistan.
India and Kenya less appealing in 2022
India offers exposure to many of these traits (particularly, leap-frogging technology, alternative manufacturing location to China, and pro-business reform) but it is no longer as cheap relative to history, particularly should monetary policy tighten at any point this year, or as committed to reform as a year ago (with PM Modi's priority now on impending state elections this year, particularly in Uttar Pradesh).
Kenya, in small EM, similarly offers exposure to some of these traits (particularly leap-frogging technology and tourism revival) but its largest stock, Safaricom, is at a premium to historic valuation, its banks are no longer at distressed valuation, the focus on the election this year continues to distract from structural reform, and external liquidity is likely to come under pressure.
Off-limits bad policy markets: eg Argentina, Turkey, Sri Lanka
A poor, foreign-investor-unfriendly policy environment rules out the following markets: Argentina, Lebanon, Nigeria, Turkey, Sri Lanka and Zimbabwe. There is sufficient opportunity at appealing valuations elsewhere in EM to avoid these.
Non-country strategy markets: Abu Dhabi, Kazakhstan
Kazakhstan (dominated by Kaspi and Kazatomprom) does not neatly fit into this country strategy framework. Hard commodities and oil is a key theme for the country but not for these key stocks.
Abu Dhabi, which is increasingly dominated by related party companies – International Holding Company, Alpha Dhabi, and Aldar – has also become something of a special situation, with the interplay between these companies already more important than, for example, oil price or regional geopolitics, for trading volume and country index performance.