Market report November 2020
Can Investors find a lasting recovery in emerging markets?
After a difficult start to the year, capital flows in both EM stock markets and bonds turned out positive. October 2020 was the fifth consecutive month of positive capital inflows into the emerging markets bond market and the fourth consecutive month of positive inflows into the emerging markets equities. This suggests that sentiment is gaining some pace, supported by the improvement in fundamental outlooks for emerging markets and the attractive valuation levels of emerging market equities and bonds compared to their developed market counterparts.
Will this trend continue? How can Investors take full advantage of the wide range of opportunities offered by emerging market assets?
Emerging economies started recovering from the post-COVID-19 crisis. North Asian countries including China, South Korea and Taiwan were most effective at fighting the virus, resulting in a milder decline in economic activity during the crisis and a faster rebound than DM (Developed Markets). Both emerging market manufacturing activity and North Asian exports have increased significantly in recent weeks. Other regions, such as Latin America, are starting to follow suit. There were signs of this in October, when emerging market equities performed better than regional equities. The solid performance of emerging stocks likely reflects the recent successes of emerging nations hardest hit in controlling the virus, while some developed-market counterparts such as the UK and France have had to re-introduce nationwide lockdowns. As a result, in 2021, I expect economic activity in emerging countries to surpass developed regions well.
Chart: GDP growth forecasts for 2020 and 2021 (percent)
Current forecasts do not guarantee future results. As of October 31, 2020
Source: RCieSolution Research
The economic recovery is additionally supported by central banks policies including interest rate cuts and stimulus packages to support growth. I believe this is a sustainable situation as inflation is expected to be low, so pressure on higher rates is likely to be small.
In addition, the relative weakness of the US dollar helps emerging market companies and countries with dollar loans to access capital markets and pay off their debts. Most importantly, it relieves pressure on indebted emerging governments and allows their central banks to pursue dovish policies. The US Fed’s policy of “lower for longer” interest rates may make the dollar weaken. A weak dollar supports the risk appetite of emerging market Investors and is usually associated with strong returns on equities and high yield bonds (HY) in emerging markets.
Emerging market asset valuations are encouraging. With emerging market companies expected to grow more than 30% next year, their stock prices appear particularly cheap compared to the DM. For example, the price/earnings to growth ratio, which measures the valuation of a stock relative to its growth potential, is only 0.44 in emerging markets, or about half the 0.82 in the US. In emerging market bond markets, HY credit spreads also look very attractive, close to 10-year highs compared to US prices. Wide spreads signal a greater chance as they narrow, prices rise and generate positive returns for investors.
Many Investors still remain aloof, especially in emerging market equities. Institutional ownership of emerging market equities now stands at 7% of total assets under management (AUM) – as low as before the strong increase in 2017, when the MSCI EM index rose 37%.
Why the reluctance to invest in EM assets? First, investing in emerging markets is generally viewed as relatively risky. It is true that in the current environment of heightened uncertainty about the pace of global economic recovery, the recent surge in COVID-19 cases in Europe, and administrative changes in the US, increased short-term volatility can be expected. The EM could benefit from US re-engagement under Biden’s presidency with multilateral institutions such as the World Trade Organization. Greater trade certainty can help export-oriented emerging countries.
Zero interest rates – redistribution through the back door
With the Covid-19 crisis, zero interest rates will perpetuate in Europe. In addition to the (negative) long-term effects of rising inequality, disruptions in financial markets and misallocation of resources, there are also direct income effects. To date, they have resulted in billions of euros ‘transfer’ from private households to the public and corporate sectors. Intermediary banks have also suffered in this process. The income effect is visible in the net interest income of sectors, which is the difference between interest income of households (e.g. interest received on bank deposits and bonds) and interest costs (e.g. interest paid on loans by households).
The government sector is one of the winners of the zero interest rate policy. Despite rising debt levels, net interest income has improved significantly: if the 2008 annual changes cumulated, the total saving would be € 195 billion (2% of GDP in 2019). Given the balance sheet of governments with only a few interest bearing assets but nearly five times as many liabilities, it is no surprise that their net interest income remains deeply negative. Nevertheless, the improvement is remarkable. As liabilities have nearly doubled over the past decade, governments’ net interest income was expected to deteriorate if not prevented by falling interest rates. In fact, the decline in rates tilted in favor of the government as shown by the improving rate differential (the difference between the interest rates for pereived debt and actually paid interest). While the perceived interest rate has decreased by 165 basis points (bp), the interest rate has dropped by 240 bp since 2008.
The corporate sector is the second big winner of a very loose monetary policy. Since 2008, its annual interest bill has fallen by more than EUR 100 billion. The cumulative annual changes amount to as much as EUR 1070 billion (10% of GDP in 2019). As with governments, financial firms have more liabilities than assets, although the liability ratio is not that extreme: it was 1.5 in 2019. From 1.8 in 2008, assets have grown somewhat faster in the last ten years than obligations. The corporate sector benefited mainly from the immediate aftermath of the GFC, when interest rates on corporate debt fell by 120 basis points in 2009 alone. This is a striking difference to sovereign debt, where interest rates have tended to fall more smoothly, reflecting the fact that long periods of fixed interest are rarely common in the corporate lending industry and therefore interest rate cuts can be carried over so quickly. Since then, interest payments have continued to decline, albeit more slowly.
Not surprisingly, private households are on the losing side of zero interest rates: they are an asset-rich sector, but their household returns have dropped to almost zero (0.6%) while they still have to deal with the interest rate on their liabilities fourfold higher (2.5%). As a result, net interest income of households decreased by EUR 55 billion (2019 compared to 2008), s cumulative changes amounted to EUR 390 billion (4% of GDP in 2019). Private households have one third more assets than liabilities.
It is time to revise the methods of capital allocation
Most Investors know the benefits of portfolio diversification and rebalancing, but putting the theory into practice can be difficult after prolonged periods of one-sided positions.
Recent developments should prompt Investors to look closely at how capital is allocated. What are the risks of your current position? Do you have enough assets that should perform well in an accelerating economic recovery or as interest rates start to rise? Are your geographic exposures sufficiently diverse? Is your exposure to growth-related equities too focused on high-valued equities or is it spread across a wider range of companies with clear growth drivers?
The answer to these questions will of course vary depending on each Investor’s risk appetite and financial goals. But when investment styles change dramatically, it would be carelessness on the part of Investors not to check that their sails are prepared for more of the potential changes that may arise.
Prior to the last shi, stock return patterns were creating large imbalances in the markets. In terms of style, for example, at the end of October, MSCI World Value was 63% cheaper than MSCI World Growth, based on a combination of three value ratios: price / sales, price / cash flow, and forecast price / earnings. This is the biggest discount in 20 years. In the United States, the Russell 1000 Value Index traded at a 57% discount to its counterpart – the growth index – also close to historically low levels.
Chart: Stock valuations are unbalanced
Historical analysis does not guarantee future results. Until October 31, 2020
The valuation discount is based on the average price to sale, price to cash flow and price to future earnings. For global equities, the valuation discount and monthly percentile ranking measured from May 31, 2000 to October 31, 2020. For US equities, the valuation discount and monthly percentile degrees from November 30, 1998 to October 31, 2020
Source: FactSet, FTSE Russell, MSCI, RCieSolution Research
Incentives for long-term growth
As growth accelerates, any questions about the sustainability of the recovery are relegated to the background. It is worth recalling, the world was not a happy place before the COVID-19 pandemic. Productivity growth has been weak and the demographic outlook weak. Moreover, the long-term outlook has been eclipsed by three trends: populism, rising geopolitical tensions between China and the West, and increased debt.
It is certainly possible that Joe Biden’s presidency will bring a temporary relief (or apparent relief) to populism and geopolitical fronts. The manifestations of both are deeply entrenched, and COVID-19 is more likely to perpetuate these trends than to reverse them. Plus, pandemic scars need to be considered. A sustained improvement in the long-term outlook is rather unlikely.
What will happen to bond yields in 2021?
The world has entered a new era of central banking in which the overarching goal of monetary policy is to facilitate financial expansion by setting bond yields at a very low level for the foreseeable future.
This primate view will be tested as growth picks up. Isn’t the bond yield unnaturally low? Are they not always rising during the recovery of the business cycle? Maybe. But there are three important counterweights to this mindset:
- Given the current level of debt, interest rates are probably where they should be – a surge would undermine the debt sustainability of many countries.
- Even before COVID-19, this was not a normal, standard cycle, a key example of which is the collapse of the relationship between unemployment and inflation.
- We have entered a new monetary / financial policy regime in which many of the old rules are unlikely to apply.
Central bankers are unlikely to describe their actions, although the European Central Bank (ECB) was close by stating that it must keep interest rates low to prevent fiscal expansion crowding out private sector spending. Instead, they continue to anchor their actions to conventional policies, describing them as shi in a function of a response designed to cause more inflation more directly.
While the ECB has not yet formally taken control of the yield curve, it is doing almost the same in practice and simply cannot do anything other than a slight increase in the yields on underlying or peripheral bonds. The task of the US Federal Reserve (FED) is likely to be more difficult, in part because the US bond market has not yet internalized the possibility that current yield levels may be “normal”. The Fed has made it very clear its new reaction function and its intention to heat up the economy to fuel inflation.
Global stock markets
The table shows rates of return in Pounds Sterling (GBP), Local Currency (Loc.) and Relative (Rel.) Date 24/11/2020.
Source: RCieSolution Research
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The views expressed in this document are not research, investment or commercial advice, and do not necessarily reflect the views of all management teams. They change over time.