Outlook 2021: Emerging markets

• There is good reason to be optimistic about the outlook for emerging markets in 2021. Vaccine news flow is encouraging, and raises confidence that by the second half of the year these should be rolled out widely. This should allow activity to recover, and support a broad economic recovery, particularly in the service sector.
• Ongoing fiscal and monetary stimulus from governments and global central banks should support a recovery in global trade and growth. This should be beneficial for emerging markets.
• There is a general consensus that the US dollar will weaken which should be supportive of emerging market assets.

The impact of Covid-19 has taken its toll on emerging markets this year and the human impact has been shocking. The degree of economic impact varies greatly by emerging country. For example, the North Asian markets of China, Taiwan and South Korea contained the virus comparatively better than global, as well as emerging market, peers.

This has been reflected in the performance of financial markets this year. There are many reasons for the wide range in returns from emerging markets. These include factors such as weaker healthcare systems, the speed of government response, and capacity to provide fiscal support, among many others. These provide a reminder that emerging markets should not be seen as one homogenous block.

While some emerging economies continue to manage second waves, the majority are seeing a recovery in activity. Our investors and economists expect this momentum to continue in 2021, aided by the discovery of effective vaccines.

Emerging market economies

David Rees, Senior Emerging Markets Economist:

“Emerging markets continue to recover from the impact of this year’s Covid-19 pandemic. In fact, many major emerging economies have contracted by less than we had initially feared, despite terrible outbreaks.

“For example, while new infection rates remain elevated in Brazil and India, the relaxation of restrictions on activity earlier this year released a wave of pent-up demand. And that appears to have driven a strong rebound in economic activity during the third quarter.

“After an estimated contraction of -1.9% this year, we are projecting an expansion of +6.9% for emerging market[1] economies in 2021. We expect China to lead the way with economic growth of around +9%.

“With the exception of China, which is likely to experience a short bout of deflation, most emerging markets are likely to experience a temporary period of higher inflation led by food. But once this passes and growth settles to more normal rates, few central banks will be in a rush to tighten policy, particularly if governments begin to repair fiscal positons.”

Emerging market equities

Tom Wilson, Head of Emerging Market Equities:

“The development of vaccines with high levels of efficacy is positive. These should deliver a normalisation in societal behaviour and economic activity through the second half of 2021 and into 2022, enabling a recovery in company earnings. Vaccine distribution is getting underway, although this will take time and may be problematic in some emerging markets.

“In the interim, a resurgence in the infection rate of Covid-19 has driven renewed weakness in global economic conditions in the fourth quarter. US fiscal stimulus has been delayed and there is potential that this not renewed until after the US presidential inauguration on 20 January. As a consequence, global growth may remain somewhat weak in the first half of 2021. An offset to this has been support from a rebuilding of companies’ inventories, which should persist into Q1. This has boosted emerging market industrial production and trade. Meanwhile, the ongoing recovery in commodity prices should benefit net commodity exporting emerging economies.

 “The outcome of US elections is relevant for emerging markets. There are run-off elections in the state of Georgia on 5 January, but our expectation is that the Democrats do not control the Senate. A Biden administration and split Congress probably mean a smaller fiscal package than a Democratic sweep would have delivered. Even so, financial conditions are likely to remain very loose for in the near term.

“Other things being equal, a Biden administration likely means a larger fiscal deficit in the US, and a weaker US dollar, particularly given that the dollar looks relatively expensive and the interest rate differential with the rest of the world has diminished. If the dollar continues to weaken and the global economy begins to reflate, emerging market equities should outperform developed markets, as the chart below illustrates.

“In relation to China, US-China tensions are likely to persist; both sides of the aisle regard China as a rising competitive threat. However, the Biden administration is expected to adopt a more methodical, multilateral approach to dealing with China.

“There has been significant dispersion in performance in markets, currencies, sectors and style factors in 2020. Countries with higher economic vulnerability to Covid-19 underperformed, as did economically sensitive/cyclical sectors. Vaccine success supported by the US electoral outcome has been driving a meaningful change in market leadership in emerging markets. It has reduced forecast risk for more cyclical stocks in particular and is leading to ongoing positive earnings revisions. Forecast risk is the probability that projections are inaccurate, which typically increases in highly uncertain times like we have seen this year.

“And investor inflows to emerging market stocks have returned. The stark undervaluation of many cyclical names has now corrected, but their valuations remain reasonable and we expect further positive earnings revisions. We also expect to see returns boosted in certain markets by currencies recovering from cheap levels.

“Risks include a turn in China’s credit impulse – this is the 12-month change in new lending as a percentage of GDP – which can be an early indicator of a change in economic activity. And looking further out, a withdrawal of monetary stimulus by central banks as growth recovers. We must also consider the longer-term consequences of a deterioration in government debt metrics in certain emerging markets.

“Longer term we would expect to see low global economic growth continue, ample support from major global central banks, a zero interest rate environment and a low return world. This suggests long-term growth stocks with asset-light business models are likely to remain in favour. The caveat here is that if stimulus is evolving from being primarily monetary-led to include sustained fiscal monetisation – effectively money printing - then we could see a persistent looser fiscal and a more reflationary environment.”

Emerging market debt

James Barrineau, Head of Global EMD Strategy

“We believe the odds are good that the US dollar will weaken over the coming quarters. A previous weakening cycle was associated with a large jump in the US current account deficit earlier in the 2000s. This is the scenario whereby the value of imported goods and services exceeds the value of exported goods and services. 

“And the trajectory appears well set for growth in both the current account and fiscal deficits in the US. If this unfolds, it should help emerging market assets in general, but particularly local currency debt. As the chart below shows, local currency debt, as measured by the JP Morgan GBI-EM Index, generated particularly strong returns in the weak dollar environment of 2003-2007.

“We estimate that currencies are generally undervalued in emerging markets. This is less so for Asian countries and more so for the Latin American region. Local interest rates have declined and are at historical lows. Despite this, relative to developed markets they still offer value when compared with historical differentials.

“The variability of inflation has declined on a long term basis across emerging markets. As a result we expect interest rates to remain stable at these levels, and central banks in general to remain on hold as economic growth heals in 2021. 

“For US dollar denominated emerging market debt, the difference in yield (spread) between high quality/investment grade debt and equivalent US Treasury yields is a mere 14% off pre-pandemic levels. Here governments have had space to increase their fiscal deficits without seriously compromising their credit ratings. And spreads relative to US similarly rated peers are attractive enough to draw investors who are not constrained to investing in emerging market debt. So while returns may not be compelling when compared to local currency emerging debt or emerging high yield debt, they are likely to rank well with global fixed income alternatives.

“In the high yield space in emerging markets, spreads remain well above pre-pandemic levels. Because the strains of a period of lower growth and higher spending will test the credit rating stability of government and companies, we do not envision spread tightening towards significantly lower levels. However yields in the 6-8% range across many credits should be attractive. Any global growth upside surprises would likely cause us to believe spreads would be justified in moving lower in this space.”

[1] Emerging market countries include Argentina, Brazil, Chile, Colombia, Mexico, Peru, China, India, Indonesia, Malaysia, Philippines, South Korea, Taiwan, Thailand, South Africa, Russia, Czech Republic, Hungary, Poland, Romania, Turkey, Ukraine, Bulgaria, Croatia, Latvia, and Lithuania.