Amid the latest bout of inflation jitters and Covid-related disruption, we update our valuation charts – these continue to suggest smaller Emerging and Frontier equity markets are significantly cheaper than Large EM and Developed. We reiterate our equity strategy view that a stuttering and uneven global recovery supports a mix of Technology, Manufacturing, Commodities, and Tourism exposure, with each segment screened for relatively cheaper value.
In these Small EM, the local investor base, driven by attractive dividend yields relative to local real interest rates, remains the key flow of marginal liquidity, given the demise of most foreign funds dedicated to these markets.
Except for the distressed or very high risk FX regimes (Argentina, Lebanon and Nigeria for those unable to exit via international dual listings, Turkey, Zimbabwe and, potentially, Sri Lanka), those local-driven flows should be sufficient for re-rating cheap equities.
Within the Technology segment, which has led global DM and EM for years but is most vulnerable to any sharp pick up yields, Alibaba, relative to Large EM peers, and Mercado Libre, relative to small EM, look the cheapest on our screen.
Equity strategy recap
Amid so much uncertainty on the biggest macro factors affecting emerging markets (EM) – the Covid pandemic, US rates and inflation, the balance of local and foreign as well passive and active flows – we recommend, in large EM, a tilt from exposure to Technology's secular growth (China, Korea, Taiwan) to the stuttering post-Covid recovery in Commodities (Brazil, Russia, Saudi) and Tourism (Thailand).
Small EM-FM is generally cheaper (apart from the Technology sector, where scarce listings attract a premium) than large EM. And it is locals, driven by low interest rates, that are the catalyst for a re-rating. In contrast, foreigners are too restricted by mainstream benchmark indices or too small, if they are the heroic survivors in the dedicated small EM-FM asset class, to drive their markets as they once did on their own. This does not stop them benefiting from better performance driven by locals.
For those able to think long term – through Covid disruption, on the one hand, and through the liquidity demands of periodic redemptions along the way, on the other – we stick to many of the long-term factors we have discussed before to determine our top picks, such as secular Tech growth (cheaper in EM than DM), macro growth driven partly by the growth of manufacturing outside China (Vietnam, Bangladesh), reform (Indonesia, Pakistan, Philippines), resilience (Qatar) and a mix of all of these factors (India).
So far this year, the pick up in US yields, the slightly stronger US dollar, the prospect of stronger fiscal stimulus in developed compared to emerging markets, US-China friction and Covid second waves have hurt the relative performance of emerging market equities in general. But this has also made for more compellingly valued opportunities across a range of themes:
China Technology (particularly Alibaba and Tencent), is among the cheapest and most liquid exposure to structural growth, which has benefited, of course, from Covid disruption but will outlast it.
Alternative manufacturing locations to China that are able to benefit from US-China friction – such as Bangladesh and Vietnam – still have positive macroeconomic transformation ahead.
Commodity exporters are benefiting from years of little capacity expansion and some are not at significant valuation premia versus history, like LatAm duo Chile and Peru (which also benefit from the secular growth in copper demand from electric vehicles and renewable energy, something absent in the oil exporters).
Tourist destinations like Thailand and others at deep valuation discounts versus history, like Dubai, Georgia and the Philippines offer recovery opportunities, for those prepared to look beyond Covid disruption.
Homegrown structural reform continues, despite the Covid shock and domestic political challenges, in markets like Indonesia, Pakistan and the Philippines.
Regardless of the foreign flows into international equity funds and the increasingly absurd misrepresentation of EM countries by benchmark index providers (eg South Korea and Taiwan have per capita incomes closer to Italy than most truly EM countries but make up 27% of MSCI EM), local investors are recognising these prospects, as reflected in the pick up in trading activity.
Out of the 50 EM and FM countries we look at, the instances where policy on interest rates, fiscal spend, FX regime or banking supervision are so poor that they fatally undermine the investment case in locally listed equities, for most foreign funds, is limited to perhaps four (Argentina, Lebanon, Nigeria for those not able to repatriate via international dual listings, and Zimbabwe), with Sri Lanka a candidate on the horizon.
Ironically, Turkey between November 2020 and March 2021 is the most recent example of how quickly and how much those funds can reward, from a low base, a return to better policy and how, as long as capital controls are not imposed, those funds can price the risk of poor policy (ie they remain engaged).
Our biggest risk factor in EM is the impact of higher food prices on countries that are reliant on food imports and where food accounts for a high portion of household consumption: Bangladesh, Egypt, Jordan, Lebanon, Nigeria, Pakistan and the Philippines. In these countries, there is a higher risk to inflation, fiscal spend (where governments subsidise or are forced to do so to stave off social unrest) and trade balances.