Strategy Note / Global

Chasing technology's tail: EM equity strategy overview

  • Asia more attractive (competitive manufacturing, stable FX, cheap) than other regions more geared to commodity exports
  • Top large EM: India imperfect but its growth and value (vs history) mix and manufacturing potential makes it top pick
  • Top small EM: Vietnam, Philippines, Indonesia (growth-value), Pakistan (governance reform), Qatar (sovereign wealth)
Chasing technology's tail: EM equity strategy overview

Have I wasted the last 15 years of my career?

In 2006 I was an analyst on global technology equities. Then I shifted to emerging markets. In compiling this overview of global emerging market equities, it feels as if I am back to covering Technology. But this time round I am looking from the outside in. The performance of most of what I look at in emerging markets appears to be chasing the tail pipe of the global Technology sector.

In the full report below, I look at how the large and small emerging markets have progressed year to date and assess them from a top-down, equity strategy perspective. Beyond the assumption that everything continues to chase Technology, Asia looks more appealing than all other regions and India, Indonesia. Pakistan, Philippines, Qatar, and Vietnam are my top markets. There are regions and markets that look too risky too.

This report is split into the following sections:

  1. Global equities

  2. Large EM

  3. Africa

  4. Asia

  5. GCC-Levant

  6. LatAm

  7. Wider Europe

  8. Global metrics footnote

There is no specific Covid-19 infection or lock-down analysis here: I stand by my view from early on in the crisis that while there is no other global economic driver so powerful, it so all-encompassing, given liquidity, trade, commodity, investment, tourism and remittance links, that picking relative outperformers on the basis of Covid-19 is misguided. For that discussion see Coronavirus: Should it be ignored because it is such an unquantifiable risk?

Also this report does not present the case for or against large or small emerging markets as an entire asset class, rather it explains preferences within the asset class. For that discussion see 7 reasons to consider investing in small EM and Frontier.

1. Global equities: Chasing Technology's tail

While the word “unprecedented” has been used widely to describe the world in 2020 the dominant feature of global equity markets looks no different from 2019 or any of the last several years: the substantial outperformance of the largest technology stocks, whether in developed markets (DM) or emerging markets (EM), and largely because of the high weights of these technology stocks, the outperformance of DM over EM and of EM over frontier markets (FM).

The FANG+ index is up over 35% year to date while MSCI World (DM) overall is down 6%. MSCI EM Technology Hardware is down 2% while MSCI EM is down 8%. Meanwhile depending on which MSCI variant of FM one considers (FEM, FM ex-GCC, or FM) the decline is in the range of 13% to 20%.

In EM and FM almost every country index is down except for China (up 5%) and those markets in dysfunctional economies where equities are acting as a liquid alternative to cash or bank deposits for trapped capital (eg Iran, Lebanon, Zimbabwe).

Unless there is a seismic reassessment of the valuation of technology stocks, then there is no reason to expect this pattern to change. Perhaps, a reassessment of technology valuations might be caused by catalysts (eg corporate frauds, cash flow distress, goodwill write downs, regulatory reviews, poorly received IPOs) which force investors to question whether:

  • Incremental returns on R&D spend and M&A are likely to fall;

  • Private equity funding is sustainable;

  • The path to profit for new business models is robust;

  • Regulatory scrutiny of dominant technology platforms is a serious threat;

  • ESG concerns are going to impact technology hardware more meaningfully; and

  • Staff compensation schemes are too dilutive.

However, all of these are arguably offset by the accelerated adoption of new technology in the Covid-19 era and the relative deterioration of growth in “old world” business models.

This is not to say that there are not undervalued, attractive equity investment cases in EM and FM. From a top-down perspective, there are several countries we highlight below which offer macroeconomic growth or transformation, stable FX rate outlook, supportive politics and reasonable equity valuation. And an at least stable US$ outlook should help the entire asset class (although the accepted wisdom that EM and FM are highly correlated with US$ weakness may be overblown).

But any active institutional equity fund looking at EM and FM will need staying power in the face of the Technology freight train (not to mention the Passive one).

There are a number of technology stocks, most of which are off benchmark because they are listed overseas, which exposed to mainly small EM and FM and these can provide a backdoor for technology exposure for institutional funds. For more on this see How to build exposure to disruptive EM tech and mitigate capital controls risk.

2. Large EM: India best mix of growth-value

China, Korea, Taiwan: Tech exposure masks rising country risk

Overall, we see India as the most attractive country in large EM. This is likely a consensus view among EM institutional funds although we would not describe ourselves as that bullish on an absolute basis. We generally see much more opportunity in small EM and FM (particularly for those driven by value and less by liquidity).

Perhaps the most ironic aspect of 2020 in large EM is the significant outperformance China, the only market with positive absolute total return. It seems an age ago (at the end of January) when reports broke of what was, at the time un-controversially, referred to as the Wuhan virus. This has been underpinned by almost a 40% weight of Technology-type stocks in the index (MSCI), local liquidity and global faith in the Chinese authorities’ control of Covid-19 (with the reported infection curve at its steepest in February). These factors likely played a bigger role than direct fiscal and monetary stimulus (which has been more modest than global peers). These factors also outweighed a host of negative factors in addition to the disruption from Covid-19;

  • Further deterioration in the US-China relationship (where both US presidential candidates regard China with suspicion);

  • Deterioration in demand from all export markets;

  • Geopolitical friction in several theatres (Australia, Hong Kong, India, Philippines, Taiwan, Vietnam);

  • Tougher US regulations on Chinese listings in the US and investment by US government-related pensions in Chinese assets;

  • Net outflows from the Asia portion of global EM equity funds; and

  • The potential catalysts of Covid-19 and worsening US relations for a long-term loss of manufacturing market share.

As US and China relations inevitably deteriorate, a host of events, eg more pervasive US restriction of foreign capital inflows to China, escalating tariffs on Chinese exports, and China devaluation, could make Chinese equities ever more reliant on local liquidity.

Elsewhere in large EM, equities exposed to Technology outperformed, with Covid-19 lockdowns driving global penetration gains for new technology applications in a three-month period that might otherwise have taken years. This pulled up S Korea, in the face of worsening relations with N Korea and an unresolved trade dispute with Japan, and Taiwan, in the face of material FX depreciation and ongoing friction with China. Similar to the FANG+ index, it is very brave to call time on the continued outperformance, in a slow growth world, of all things Tech.

Common to the underperformers in large EM is a relatively traumatic experience in dealing with Covid-19, through a mixture of denial and incompetence or an acceptance that lives lost through increased poverty from lockdowns would be greater, ultimately, than those from the virus. The drop in oil and commodity prices has hurt Brazil, Russia and South Africa more than India.

Brazil: reform balloon deflates

Brazil’s shift to a more pro-reform environment after the election of President Bolsonaro at the start of 2019, evidenced by initial success in building sufficient support in parliament for pension reform, has unravelled (eg efforts to simplify taxation or reduce bloated public administration appear stuck) because of a number of political factors:

  • Divisions within Bolsonaro’s political bloc (he left the party which backed his presidential campaign); Lack of majority control of parliament;

  • Distraction and fallout from suggestions of corruption (culminating in the resignation of the Justice Minister in April);

  • Growing distance between President Bolsonaro and his Finance Minister Guedes; and

  • Increasing electoral risks associated with reform (municipal elections are scheduled for October 2020) following regional protests, particularly in Chile, against social inequality, and the election loss for right-leaning Macri in Argentina in 2019.

The hit to growth from lower commodity prices and the Covid-19 (which was compounded by the unwillingness to acknowledge the virus initially, the incompleteness of lockdowns, and the tardy economic stimulus) has reinforced the political reluctance to tangle with unpopular structural reform.

South Africa: value but insufficient reform to unlock it

South Africa is the only market in large EM which is on a large discount to its historic valuation multiples and to developed markets (India is at a smaller discount to history but still trades at a premium to DM).

Adding to the negative impact on growth from lower commodity prices and Covid-19 disruption, is the lack of political will to enact urgently needed fiscal reform, specifically sustained spending and public wage cuts, and restructuring and privatisation of state-owned enterprises (particularly Eskom).

In turn this lack of political will is due to internal divisions within the ruling ANC party and the power of public sector unions.

In the absence of credibility on reform, South Africa appears consigned to poor growth, rising government debt, and potentially, increasingly unpredictable and populist policies (land expropriation without compensation, unfunded universal health, tax exemptions for selected industries, and higher costs for corporates for Black Economic Empowerment.

It is tempting to look at all of these risks as reflected in the valuation discount to history (ie investors could now be more sensitive to any positive news rather than simply another confirmation of what they already fear). But without being able to identify what might turn things around (a crisis severe enough to galvanise reform, or a reconciliation between economic leftists and liberals in the ANC), we expect continued deterioration.

This suggests continued outperformance by Naspers versus locally driven stocks.

Russia: lower oil price offsets (temporarily) lower foreign policy risk

Russia might be a more attractive option than Saudi among the large oil exporter equity markets but, from a top-down perspective, it does not look compelling on an standalone basis. Russia can weather the oil price drop more comfortably than Saudi and the GCC (ex-Qatar), with its lower fiscal break-even oil price, flexible FX rate, rebuilt FX reserves and less welfare-dependent population, the absolute economic hit is undeniable.

However, the hopes of a shift from fiscal consolidation to more pro-growth policies, signalled by the appointment of the new cabinet under new PM Mishustin in January, may have been dashed. Domestic political risk has also increased as a result of President Putin’s deteriorating popularity and, on the foreign policy front, while relations with Ukraine are more constructive and US sanctions are unlikely to worsen, the conflicts in Libya and Syria show little sign of resolution and the next one, in the Arctic, is just starting.

India: imperfect but best mix of value (vs history) and growth in large EM

India sits at a crossroads for the investment case in equities:

  • Economic reform is less certain (given PM Modi’s focus on social reform) but the scale of the untapped consumer and manufacturing base remains unrivalled;

  • The military costs of more self-reliant foreign policy are likely to escalate (to counter Chinese efforts to establish influence in ocean territory critical to its trading routes and to offset the unpredictability of US foreign policy) but China‘s ‘9-Dash Line’ and String of Pearls’ policies are also driving the ‘Quad‘ (Australia, India, Japan, and the US) closer together;

  • Growth in lending, corporate earnings, and the broad economy is decelerating but the premium in equity market valuation multiples relative to peers and developed markets has also shrunk.

India remains the biggest single country opportunity in EM and FM. There are pockets in the current listed equity universe which do not provide compelling pure plays on future growth (struggling financials and real estate) but there is plenty of exposure available in the consumer and telecom sectors.

3. Africa ex-SA: Egypt the least bad

Covid-19 remains a significant economic challenge across the continent: while the youthful demographic should mitigate deaths, low testing casts doubt on modest infection rates, tourism, remittances, and FDI are negatively impacted, capacity is limited for fiscal stimulus (because of rising debt levels in recent years) or interest rate cuts (because of FX rate sensitivity), and changes in foreign portfolio investor risk appetite (or fund redemptions in the case of the remaining pan-Africa or global Frontier funds) can overwhelm trading activity in what remain very illiquid markets (by global standards).

This combination of factors is best demonstrated in Mauritius, the region's worst performer, where the FX rate has depreciated c10% ytd, Moody's sovereign credit outlook was downgraded to negative, and the national statistics agency forecasts a 70%, 45%, 20% and 13% drop in tourist arrivals, textile output, construction activity, and GDP, respectively, in 2020.

A number of equity markets in the region are, to varying degrees, dysfunctional: foreign repatriation is not possible in Zimbabwe and severely impaired in Nigeria, price discovery remains compromised in Tanzania, and Mauritius was shut for two weeks at the end of March.

Among the region’s larger stocks, Telecom Egypt is the only one which is up significantly in absolute terms ytd (c30%), handsomely outperforming. This for the company-specific reason of a potential release of value in its 45% stake in Vodafone Egypt, following Saudi Telecom’s intention to purchase the majority 55% stake from Vodafone.

Egypt: another IMF deal, slower rate easing, higher foreign policy risk

Egypt rapidly secured external funding (from the IMF and the Eurobond market), offsetting prior FX reserve erosion, and it remains the only market in Africa ex-SA on valuation multiples well below historic average.

However, political risk has deteriorated. Egypt is rattling its military sabre in response to setbacks for its ally in the Libyan civil war (LNA forces led by Haftar) and in its diplomatic efforts to block or at least slow) Ethiopia’s progress in filling up the GERD (which threatens downstream fresh water supply for water-poor Egypt).

While interstate war is unlikely, higher direct spending on the military is a bigger risk (after a decade during which this has fallen by a percentage point of GDP). This would be unwelcomed for the investment case given the military’s continuing, overbearing indirect grip on the economy and the strain put on the fiscal deficit from Covid-19 disruption.

Morocco: reminder of succession risk

Morocco’s King Mohamed has undergone his second heart operation in as many years (Crown Prince Hassan is merely 17 years old). Succession matters because of the central role of the monarchy and the royal court in policy-making.

Morocco faces ongoing challenges externally to maintain good relations with the EU, as well as both sides of the GCC, and cultivate closer ones within the AU, and, internally, to manage the sense of exclusion felt by the Berber ethnic group, maintain the inclusion in formal politics of the moderate Islamists, and counter the separatist risk from Polisario in the Western Sahara.

Nigeria: false outperformance as the scourge of FX dysfunction returns

Nigeria has outperformed Africa and Frontier equity peers ytd despite the drop in oil price. Regulatory changes which have restricted access to central bank securities (open market operations), high dividend yields, and the cut in interest rate may have pushed some local wealth into equities.

But this performance is illusory: most foreign institutional funds looking to exit are be trapped by FX shortages (which are likely to persist), dampening falls in share prices.

Kenya: Safaricom’s outperformance of the Banks amid high risks for all

Kenya has outperformed despite the divorce in the leadership of the ruling party, persistent fiscal and current account deficits, an over-valued FX rate, insecurity, and the damage to remittance flows and tourism from Covid-19. The threat from locust swarms has recently receded but only after exacting a toll on the economy (agriculture is 35% of GDP). This list of risks keeps us cautious.

Total equity market performance masks the dichotomy between mobile telecom operator, Safaricom, which dominates the index and has outperformed the rest (eg the Banks). Safaricom's exposure to the staple revenues of mobile voice and data and Covid-19 induced penetration gains for the digital payments sector (although regulation of transaction charges is dampening the near-term revenue impact) have likely driven this. Furthermore, Safaricom shares are far more liquid (average daily traded value of US$2.5m is 50% higher than the combination of KCB and Equity). Yet, such a large disconnect in valuation and performance is perhaps too great for two sectors ultimately exposed to the same economy.

Zimbabwe: dystopia

Zimbabwe’s equity performance should continue to be ignored because it reflects equities acting as a substitute for cash in a collapsing economy for locals and foreigners in the formal sector who are trapped within a dysfunctional FX market. There has been no progress on debt arrears to the World Bank, and poverty and food insecurity were critical prior to Covid-19.

4. Asia: Vietnam tops a strong group

With the exceptions of China, Malaysia and Vietnam (assuming reported data is accurate in both) all of Asia has struggled with Covid-19 and most of the large population countries have concluded that the poverty caused by long-term lockdowns will cause more deaths than the virus. Bangladesh, India, Indonesia, Pakistan, and Philippines have fared particularly poorly (in all of these high share of informal labour, extreme urban density and deficient public healthcare have been contributory factors). Better healthcare infrastructure, smaller population, and more developed tracking security apparatus has allowed some (eg Singapore, S Korea) to combat Covid-19 better but not without encountering second waves of infection.

The outperformers in Asia ytd are Malaysia and Vietnam. Longer-term, both stack up well as potential long-term beneficiaries of manufacturing investments outside China (on the basis of a mix of low costs, support for higher technology, and governance) but the same could be said of Indonesia, which has underperformed along with Pakistan and Sri Lanka. Philippines and Thailand performance sits in the middle of these two groups.

Malaysia: outperforming but fractious politics is getting in the way

Malaysia’s outperformance is perplexing.

Firstly, the domestic political environment has worsened: the change in government (from PM Mahatir to PM Muhyiddin) and the ongoing challenge to the new government’s mandate is causing delays in the reforms needed to escape the “middle income trap” (better infrastructure, more efficient public procurement, empowering anti-corruption, increasing female labour force participation, and improving the ease of doing business) and increasing the risk of non-Malay ethnic disenfranchisement.

Secondly, most of the external drivers for Malaysia have deteriorated this year: global demand for technology hardware, US-China trade relations, and oil and palm oil commodity prices. Thirdly, valuation, at the index level, is merely close to historic average.

All of these leads us to a cautious view outlook for Malaysia equities.

Vietnam: firing on most cylinders but tight FOLs still a constraint

Vietnam has justifiably benefited from a formidably successful healthcare response to Covid-19 (zero deaths, under 400 infections, despite its location on China’s border). Its valuation is still at an approximately 10% discount to historic average.

Given the structural aspects of the investment case are unchanged (sustainable growth in exports, consumption, and infrastructure, stable FX rate are the positives and offset the risks of party leadership succession before the 2021 congress, an aging population, and sluggish state owned enterprise reform), Vietnam remains our top country pick among the smaller EM and FM markets in our coverage.

Of course, tight foreign ownership limits (with seemingly little urgency by the authorities to remove them) remain a constraint on fresh allocation of capital to Vietnam by foreigners. The effective foreign available free float of the MSCI Vietnam index is merely 20%

Philippines: cheap but Duterte’s succession may take priority over reform

Philippines has seen two important developments apart from Covid-19 disruption: the repair (at least temporarily) of relations with the US, evidenced by the delay in scrapping the Visiting Forces Agreement) and the detente in relations between President Duterte and big local businesses.

Philippines shapes up fairly well as a candidate to attract new manufacturing investment but structural reforms of taxation and infrastructure likely become less of a priority than political preparations for the post Duterte presidency (which may include establishing a succession path for his daughter Sara, and mayor of Davao City).

Equity valuation is attractive relative to history but a loss of urgency behind structural reform and the increased risk to remittances from the GCC make the Philippines less attractive than other countries in Asia.

Indonesia: cheap and slowly improving but patronage still slows reform

Indonesia continues to tick along, adjusting for Covid-19 disruption. President Jokowi is early in his second term but there does not appear to be any greater urgency to implement the upgrade to infrastructure and human capital to accelerate structural growth.

After China and India, Indonesia has the largest labour force in Asia but burdensome regulation keeps it a fairly inflexible one and the scattered island geography and highly heterogeneous population of Indonesia both inhibits the establishment of competitive logistics and fosters a culture of patronage (which maintains national unity but blocks difficult decisions which might prioritise one community over another).

Low equity valuations relative to history keep up positive on Indonesia but this is not enough to make it our favourite in the region.

Pakistan: Covid-19 blow but cheap and governance reforming

Pakistan’s economic improvement has been derailed by Covid-19, reversing growth (despite large interest rate cuts), widening primary fiscal deficit (due to lower tax revenues), weakening FX rate, and while lower oil prices alleviate the import bill this is offset by greater risk to remittances from the GCC. The silver lining is decelerating inflation and rapidly mobilised external funding (IMF, Asia Development Bank).

Governance reform continues with an unprecedented public investigation into unjustifiable price inflation by the sugar cartel (which has led to a casualty within the most senior echelon of the ruling party, Jehangir Tareen in the PTI - something unthinkable under previous civilian or military governments) - and restructuring of state-owned enterprises (eg Pakistan Steel Mills).

While military friction continues the Indian border, the confrontation between China and India is a reminder that there is an overall balance of power which constrains both sides.

Pakistan is still cheap enough and economic policy, including FX rate flexibility, is sensible enough to merit an investment case based on structural improvement in governance (a root cause of corruption, economic short-termism, and insecurity) and infrastructure (China Pakistan Economic Corridor).

Sri Lanka: cheap but loose fiscal policy unsustainable

Sri Lanka’s fiscally looser turn under the leadership of the Rajapaksas appears to be costing it timely assistance from the IMF. Although external obligations should be met the delayed election (from April to August) means the parliamentary passage of the budget (which may need the Rajapaksas to establish an outright majority and on which a new IMF program may be contingent) is also delayed. Although Sri Lanka equities are cheap, the banks may struggle to expand credit

Bangladesh: kleptocracy is wasting great potential

Bangladesh’s equity market performance is misleading.

The market finally re-opened after over a two month hiatus blamed on Covid-19 (but more likely driven by politically protected local high net worth and institutional vested interests seeking to avoid margin calls on marked to market portfolios). However, the mechanism for setting the limit-down share prices at artificially high levels remains and this prevents sizeable liquidation by foreign institutional funds (which, in turn, means that the depth of the FX market to support repatriation is not tested).

This adds to the ever more ad hoc, unfriendly to business, and kleptocratic policy record of the Awami League: eg targeting of Grameenphone back taxes and new products, lending rate cap in banks, taxes on formal tobacco, delayed pharmaceutical price increases.

The fig leaf of garment export growths, which hides these defects in the investment case, has also been removed: garment exports were in decline prior to Covid-19 disruption (falling 6% yoy in 2H CY2019 before accelerating to a 14% yoy drop for the 10 months to April 2020).

5. GCC-Levant: old models under stress

The GCC-Levant region is split between those markets valued close to their historic average (Abu Dhabi, Bahrain, Kuwait, Qatar, and Saudi) and those at large discounts (Dubai, Jordan, Oman).

Markets in the former group have been dominated in recent years by institutional inflows and trading activity related index changes (MSCI and FTSE). This attention (distortion) should fade after the last major index weight related change: Kuwait's accession to MSCI EM in November 2020.

GCC: the old model is stressed, Qatar is a partial exception

The established economic model of converting hydrocarbon revenues into sovereign wealth and citizen welfare (via corporate and consumer subsidies and quasi-permanent jobs in the public sector), relying on transient expatriate labour, gradually diversifying into non hydrocarbon-based, privately owned sectors, and maintaining fixed FX rates is under threat from oil prices well below fiscal break-even for the foreseeable future, rising government (including government related enterprise) debt, and the millstone of an uncompetitive exchange rate around efforts to develop exports outside natural resources.

All of this is exacerbated by a lack of coordination to avoid duplication in diversification strategies (all seemingly targeting transport, tourism, entertainment, and finance), foster more intra-regional trade, minimise aggregate military expenditure, mitigate financial contagion risks, negotiate free trade agreements on a collective basis, and avoid competition on tax and visa policies. The Qatar blockade passed its third anniversary in June with no clear path to resolution of the geopolitical disagreements which preceded it.

The onus of economic stimulus amid Covid-19 disruption is borne by fiscal policy, given the handcuffs on interest rates (which have to be tied to the US rate cycle in order to maintain the FX peg). Low oil prices mean that deficits inevitably expand, from already wide levels, to preserve growth, at least in the non-oil sectors. Saudi and Oman have chosen to cut fiscal spend which may be the prudent decision in the long-term for the sovereign balance sheet but this means that the growth slowdown is likely to be relatively worse, compared to, for example, Qatar (which announced a fiscal stimulus equivalent to 10% of GDP to combat Covid-19 disruption).

Oil prices have partially recovered from the coincidence in 1Q 2020 of the breakdown in OPEC+ output restraint and Covid-19 induced demand collapse but they remain below fiscal break-even for the GCC oil exporters (which range approximately US$55-95, with Kuwait at the low end and Bahrain at the high end) and they are back close to the range (US$45-55) for operating break-even for US Shale.

For those who are sceptical of diversification efforts across the GCC (ie the old economic model is too entrenched) then Qatar, with its enormous sovereign wealth (roughly US$1m of sovereign wealth and FX reserves per citizen), can likely sustain this old model for longer than GCC peers.

Saudi: reform struggling to attract private sector capital

Saudi reform has much low-hanging fruit to pick but remains impaired by:

  • Much higher Saudi citizen wage costs compared to expatriates;

  • Rising government taxes (eg the tripling of VAT this year, from 5% to 15%) and fees;

  • Lower confidence in the local high net worth base to invest domestically (given the concentration of power within the ruling family, the cut to corporate subsidies, and the Ritz Carlton Affair); and

  • Dented foreign direct investor interest (given the fallout from the Khashoggi Affair and ever stricter ESG criteria on extractive industries and carbon emissions).

Kuwait: back to its old risks after EM index inflows

Kuwait remains relatively slow-moving because of obstructionism in its generally populist parliament. The following factors may bring this issue into focus:

  • Need to pass a new debt law in order to issue Eurobonds;

  • Rising anti-expatriate populist sentiment in the Covid-19 era;

  • An election is due in 2020; and

  • Succession for the Emir (aged 91) or the Crown Prince (82) requires, we understand, parliamentary approval.

UAE: deeper reform of residency visas needed

Although Abu Dhabi is valued a little more cheaply (relative to its history) compared to its small hydrocarbon-rich peers (Kuwait, Qatar), and there is rationalisation of overlapping parts of the state-owned enterprise sector (eg M&A among Banks and sovereign wealth companies) it continues to bear the implicit contingent liabilities of Dubai Inc and the other Emirates in the UAE.

Dubai is the most externally exposed country in the region and is, therefore, the most geared to any pick-up in growth if Covid-19 disruption dissipates. But pre-existing risks persist:

  • Oversupply of completed real estate;

  • High operating and living costs;

  • Narrowing space for geopolitical neutrality in the region; and

  • Insufficient reform of long-term residency permits for expatriates.

Oman: new ruler, old challenges

Oman navigated its succession relatively smoothly at the start of this year but remains highly geared to the long-term outlook for oil prices (given its fiscal break-even of about US$85, meagre sovereign wealth of US$7k per citizen) and potential financial assistance from its richer GCC neighbours (which will likely come with geopolitical conditions in terms of relations with Iran) or the US (which will likely come with conditions on relations with China, which is a major investor in the country’s ports and electricity utility).

Bahrain: not getting to grips with fiscal sustainability

Bahrain is grappling with high fiscal breakeven oil price (over US$90), government debt of about 130% of GDP, meagre sovereign wealth of US$30k per citizen) and is ever more reliant on very close relations with (implicit guarantees from) neighbouring Saudi. Its finance and hospitality sectors remain in competition, respectively, with Dubai and Saudi.

Its equity index is something of a misnomer: Ahli United Bank (AUB) makes up almost 70% of MSCI Bahrain and 30% of the BB All Share, and its share price performance is largely driven by the likelihood of its takeover by Kuwait Finance House being completed (the deal is being reassessed after the April 2020 directives by the finance minister and central bank in Kuwait).

Lebanon: dystopia

Lebanon’s outperformance should be disregarded given the dysfunction in the local economy (growth collapse, hyperinflation in food, Banks shareholder value wipe-out, civil unrest) and the FX market. With all political vested interest groups seemingly absolving themselves of responsibility for economic collapse and social unrest, equities are acting as a partial proxy for illiquid bank deposits (on a smaller scale to Zimbabwe).

The reported US$ total return performance is merely notional: foreign repatriation is barred by capital controls and the parallel FX rate has widened to a 60-70% discount to the official peg so far this year).

6. LatAm: Commodity price headwind

LatAm often displays a degree of exceptionalism compared to peers in EM.

This is because of its proximity to the US which means corporate management are historically more accessible to the largest concentration of foreign institutional investors, individual US-based portfolio managers with the longest experience generally looked at LatAm before other global EM, ADRs, particularly of stocks in Argentina or Peru, are easily accessible from a trading and custodian perspective and avoid the pitfalls of trapped FX.

All of this perhaps leads to LatAm being much more closely geared with the ebbs and flows of risk appetite: quicker liquidation by foreigners in a crisis and a quicker return afterwards. For example, Colombia is one the worst performing oil exporter equity markets, despite its fiscal strain being a common feature across this peer group, and, as a region, LatAm FX rates have depreciated the most ytd (down 6-25%, with Peru the least and Brazil the most).

Structural weakness means commodity prices dominate the investment debate

Structurally, LatAm is one of the least appealing regions in global EM: wages are already relatively high, labour force scale is small outside of Brazil, economic and social inequality is stark, commodities dominate exports (with the exception of Mexico), intra-regional trade is limited, governments in LatAm’s highly competitive democracies have insufficient time or mandates to see through deep-seated reforms (three recent examples are Macri’s failure in Argentina to back fill his early success in raising capital with lasting fiscal consolidation and inflation control, Vizcarra’s inability in Peru to erect stronger checks and balances on parliamentarians and judges, despite popular support, and Duque’s ability in Colombia to dilute the practical implementation of the agreement reached by his immediate predecessor with FARC rebels).

The investment case in LatAm markets tends to be most compelling when commodity prices are on an upswing or global risk appetite is expanding (of course these two factors are often coincident). The current anaemic global growth outlook does not appear, sustainably, to support those factors.

In addition to this, the derailing of Bolsonaro’s reform agenda in Brazil electoral loss for Macri in 2019 in Argentina, the inability of Duque to implement fiscal control in Colombia, and the mass protests against social inequality in the region, particularly in Chile, may portend a broad shift back to left-leaning, less business-friendly political parties in the next respective electoral cycles. The political shift leftwards occurred in Mexico at the end of 2018, with the election of President Lopez Obrador (AMLO).

Mexico: fears on AMLO versus hopes of US recovery

Mexico is the region’s exception in manufacturing because of its physical proximity and low tariffs to the US. Indeed, outside of Asia it might be one of the few long-term beneficiaries of diversification of manufacturing capacity away from China.

But the investment case is spoilt by the fiscally populist shift under President Lopez Obrador, low oil prices (which exacerbate the stress in Pemex debt and act as a drag on the overall economy), and the slowdown in US growth (US exports and remittances equate to 28% and 3% of Mexico GDP, respectively).

Equity valuation is at a discount relative to historic average, arguably reflecting many of these risks and providing a sufficiently attractive entry point for those expecting a rapid recovery in US growth.

Argentina: stuck in default negotiations

Argentina remains, at the time of writing, locked in negotiations with creditors after its ninth sovereign default.

Capital controls are also in place which means fresh foreign capital can consider the ADR listings alone. The problem is that ADRs of companies with little exposure to the domestic economy, eg Mercado Libre or Globant, have already outperformed to a massive degree (by 50-80% versus MSCI Argentina).

Any positive resolution could provide a boost to stocks driven by the local economy. However, without confidence that the creditor negotiations will resolve in an orderly manner, the FX rate has stabilised, much stricter fiscal consolidation is on the way, and the Banks will not have to raise more capital to withstand the macroeconomic reset, there is little on which to base a positive call.

The Macri episode (hesitant reform because of the need to generate better growth before the next election, followed by electoral defeat to the Peronists, who re-established internal unity and remained organised at the grass roots level) demonstrates the difficulty of structural reform (fiscal deficit control, weakening of the grip of organised labour on wage-setting). The Peronists led by President Alberto Fernandez are not (yet) as market unfriendly as the previous incarnation under Cristina Fernandez but they are no better placed (or inclined) to pursue reform than Macri’s Cambiemos coalition.

7. Wider Europe: Kazakhstan worthy outperformer

“Wider Europe” refers to a geographically disparate collection of countries (stretching from Eastern Europe and former CIS, to Turkey, and to Iceland). All have significant trading links to the EU (but this is also the case for Morocco and Tunisia in North Africa). Some are commodity exporters (eg Kazakhstan in oil, Ukraine in food), some are very dependent on tourism (eg Croatia, Iceland), some are EU members (eg Poland, Romania), and some are EU and Eurozone members (eg Estonia, Slovenia).

Turkey: ever decreasing circles

Turkey remains locked in recurring cycles:

  • The economic boom and bust driven by unorthodox interest rate policy;

  • Bouts of domestic political disruption (and hyperactive foreign policy) driven by President Erdogan’s desire to retain his grip on power; and

  • On-off relationships with both the US and the EU driven by Turkey’s geopolitical role as a buffer to Russia and Iran, for the US, and as a gas transit route and migrant buffer, for the EU, for which Turkey seeks concessions in other areas.

Turkey faces the prospect of having to tame inflation, pump credit to sustain growth, and maintain FX rate (an impossible economic policy balancing act), and to manage territorial conflict on multiple fronts (East Mediterranean, Libya, Syria, Iraq).

This lengthy list of top-down concerns spoils the investment case in Turkey’s well managed, cyclically robust, and cheaply valued listed companies.

Kazakhstan: positives outweigh low oil price and succession risk

Kazakhstan does not appear to be accelerating its reform and privatization efforts in response to Covid-19 disruption and the oil price drop. This may be down to the distraction of an incomplete succession to former President Nursultan Nazarbayev, who remained a grey eminence after stepping down and, if anything, has become a little more publicly active this year. Current President Tokayev appears to have started to cement his position with the removal of Nazarbayev’s daughter, Dariga Nazarbayev, and potential rival, from her role as Senate Speaker.

Nevertheless, Kazakhstan has orthodox economic policy, flexible FX rate, healthy FX reserves, significant sovereign wealth, an ongoing infrastructure upgrade, and an almost unique range of geopolitical support (US, Russia, and China). Its larger stocks (eg Halyk Bank) remain relatively cheap compared to history and are easily accessible via London listings.

Overall, there are enough positive factors in the investment case to make Kazakhstan our top pick among wider Europe peer group.


Iceland will be a new inclusion in the MSCI FM index (in May 2021) - of course, it is far wealthier (US$74k per capita GDP) and more liquidly traded (over US$5m per day) than most new markets in FM.

After a decade of successful repair following the 2008 financial crisis, the current macroeconomic challenges are slow growth in the EU (the largest market for aluminium and fish exports) and Covid-19 disruption to the tourist sector (13% of GDP, with 30% of arrivals are from the US, 15% from the UK).

For portfolio investors restricted to FM, Iceland offers very defensive sovereign risk (rated A3 by Moddy's) and exposure to a high quality global industrial (in food processing equipment) via the largest stock, Marel (over 40% of MSCI Iceland). But neither Marel nor the other main index weight, Arion Bank, are cheap relative to history.


Romania awaits a parliamentary election in late 2020 or early 2021.

The establishment of a government with a stable majority coalition and pro-business policies is still possible but not as probable as at the start of the year when the liberal PND had an almost 20pp opinion poll lead over socialist PSD (this is now nearer 10pp, which likely portends a more fragmented coalition with more smaller parties). Covid-19 related delay to any election is potentially significant: the longer the delay the more the memories of the PSD’s unpopular judicial reforms fade, the more the PND is tarnished by an economic slowdown, and the longer fiscally loose policies merely offset some of the disruption from Covid-19, rather than curry favour with voters.

While regulatory and economic policy has reverted to a more orthodox, predictable, and business-friendly direction after the fall of the PSD government in 2019, equity valuations are no longer distressed, a weak coalition could still emerge from the next election and EU growth remains weak.

8. Global metrics footnote

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