There’s a new leader in town
Investors who are globally diversified may be seeing that pay off at the start of 2021. Emerging market (EM) stocks are ripping, up 8.2% year to date for the MSCI Emerging Markets index versus 3.2% for the S&P 500, as of February 22. More than that, EM’s surge means it’s the current performance leader off the stock market lows of last year.
Post-pandemic economic reopening is a big EM driver, but not all reopening themes are winners. Value stocks, for example, are badly trailing.
Horizon Investments believes there are fundamental reasons that will drive emerging market outperformance for the foreseeable future. Here’s why we remain overweight EM in the global equity portion of our strategies.
All roads lead to China
Our EM analysis has to begin with China, which has grown to about 30% of the MSCI Emerging Markets index. China was the first country to suffer due to the pandemic, and now it’s recovering earlier than the rest of the world. There is a V-shaped recovery in much of the country’s economic data, indicating it – and therefore the wider Asian region – are far ahead of the West with respect to reopening. As a result, China’s GDP growth this year will return to beating the United States by a wide margin, according to economist forecasts compiled by Bloomberg.
2021 GDP growth forecasts:
- China: 8.4%
- U.S.: 4.8%
Government stimulus globally, alongside a virus in retreat, suggests to us that growth is going to be strong in the second half of this year.
Year-to-date is nice, but long-term EM is …
While EM is off to a fast start to the year, skeptics won’t be impressed. That’s because the last decade has been a boon for investors who bought and held the S&P 500 rather than the world’s developing economies – which is clear in terms of relative performance.
While this year hasn’t changed the long-term picture, EM’s past difficulties don’t take account of the evolution that’s occurring.
This is a new kind of EM
Twenty years ago, emerging market stocks were led by economically-dependent cyclical sectors. Today, it’s the growth-oriented industries of technology, consumer discretionary, telecommunications services and healthcare that dominate, accounting for nearly 60% of the MSCI EM index’s market capitalization as the energy, materials and utility sectors fade.
And if U.S. stock indexes are any indication, once sectors such as tech and e-commerce rise in market cap, their dominance tends to have staying power over cyclicals through deep recessions and fast recoveries.
Services rising, factories fading
The increasing index weighting towards growth sectors is a reflection of two large Chinese companies: e-commerce leader Alibaba and social media firm Tencent. At the moment, they’re among the biggest weights in the MSCI EM index. Their ascension reflects a fundamental change in China. The country’s economy is now dominated by services, not manufacturing, as we showed in our Q4 Focus report.
Services industries don’t have inventory cycles, unlike factories which do. And that could smooth out the economic ups and downs for EM countries and the equity markets tied to them. Services businesses generally also carry higher profit margins than cyclicals, something that could buoy EM equity price-to-earnings ratios.
What could derail the emerging markets’ rally? The dollar is one risk. Its recent weakness has helped emerging market assets rise in value. But the dollar could turnaround if U.S. GDP growth is surprisingly strong and interest rates rise, driving up investor demand for the greenback. Another important factor determining the attractiveness of EM would be any resurgence of lockdowns to combat the pandemic.
With faster post-pandemic economic growth this year, a larger services sector, a tilt towards tech industries and rising wealth in China, Horizon Investments believes the ingredients are there to support EM outperformance over the S&P 500 for the foreseeable future, which would benefit those investors who have a portion of their portfolio allocated to global stocks.
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