New policies in China have rattled markets. What are the implications for EM investors?
Patricia Ribeiro: Recently announced federal regulations in China have understandably concerned investors and unsettled markets. We think the central government is carrying through on pledges to prioritize fairness and stability.
These changes address areas the government considers important to the public interest and strategic policy goals. For example, they aim to boost discretionary income and population growth, which is consistent with the government’s stated emphasis on fair growth and common prosperity.
The new rules are intended to create a fair and orderly business environment for sustainable development. Several main objectives include:
- Containing financial risk by regulating leverage ratios for property developers and internet finance companies.
- Enforcing antitrust rules to reduce monopoly power by eliminating exclusivity in merchant contracts or platform choices.
- Improving data security by increasing government oversight to regulate the collection, storage and use of consumer data. Plans are also designed to strengthen cybersecurity to reduce national security risks for trading data-rich companies on exchanges overseas.
- Reducing social inequality by promoting social fairness and wealth creation. Goals include improving health care access, reducing medical costs, easing the burden of educational expenses, and increasing the housing supply.
- Reforming capital markets to support the continued opening of China’s financial markets and financial sector to foreign investors. Policies should promote a healthy domestic stock market by reducing volatility and speculation and strengthening supervision of companies traded on exchanges overseas.
Do you expect additional regulations in China?
Ribeiro: The regulatory overhaul in China is related to the government’s long-term development and modernization agenda. So, we may see more changes related to citizens’ well-being, such as health care services, food and drug safety, housing and labor protections. It’s our view that new rules are likely in these areas, and the most stringent regulatory changes are likely behind us.
Notably, companies positioned to help address China’s economic agenda continue to receive strong policy support—e.g., firms involved in electric vehicle manufacturing, cloud computing, innovative drug development and high-end domestic manufacturing.
How have EM regions performed differently?
Ribeiro: Emerging markets isn’t a homogenous asset class, there are notable regional differences. Several factors contribute to this divergence.
Asian growth companies currently dominate the MSCI Emerging Markets Index, while the number of firms in Europe, the Middle East and Africa (EMEA), and Latin America (LatAm) have declined as a percentage of the overall index.
While EMEA and LatAm companies have historically been more cyclical than Asian firms, the prolonged spread of COVID-19 has hindered domestic recovery and pressured Asian markets. In China, tighter regulation of the technology and education sectors has also negatively affected the market.
Commodity sectors also comprise a larger part of the EMEA and LatAm indices relative to Asia. These have benefited from tight supply and higher prices prompted by the global economic recovery and gradual transition to green energy.
We continue to watch cyclical sectors with a focus on reopening economies and reflation. Increasing economic momentum is helping us find opportunities in the materials sector, including recovery and infrastructure spending, and financials.
Looking ahead, what economic tailwinds do you see for emerging markets?
Ribeiro: We think there are several reasons for optimism as these countries begin to put the worst of the pandemic behind them. Tailwinds include a favorable growth outlook, strong earnings momentum and compelling valuations.
How will EM economic growth respond as countries start to recover from the pandemic?
Ribeiro: We think countries emerging from the pandemic now have more room to grow.
We expect growth momentum to shift toward those economies that have taken longer to exit the pandemic. For example, EM countries outside North Asia have rebounded recently. We expect this to continue, given that growth in many of these economies remains below pre-pandemic levels.
Economies in EM North Asia—mainland China, South Korea and Taiwan—have fully recovered in terms of their gross domestic product (GDP). This is in stark contrast to other regions. EM economies outside North Asia have more room for growth and return to pre-pandemic levels relative to the U.S. or EM North Asia, making them potentially attractive. Examples include Brazil and Mexico.
Conversely, we think China, which handled the early waves of the pandemic better than most countries, has much less potential room to recover. EM GDP forecasts have been revised more positively compared with those of developed markets. Yet, EM equities have underperformed compared with relative growth expectations.
What is your outlook for EM earnings?
Ribeiro: Recent earnings trends are favorable for EM equities. Second-quarter 2021 earnings announcements have been strong, supported by the relaxing of COVID restrictions and an acceleration in economic momentum. We expect the upswing to continue throughout this year.
While EM earnings haven’t been meaningfully weaker than those in the U.S., EM and U.S. equity performance have been quite different this year. EM equities have been largely flat, driven by weakness in China. This implies the correlation between EM earnings and equity performance is low by historical standards.
How do current EM valuations compare to developed markets?
Ribeiro: They remain attractive relative to developed markets. The discount is notable, considering emerging markets has shown earnings growth and earnings revisions comparable to those of developed markets. Asia, EMEA and LatAm are each trading at higher-than-historical-average discounts to the U.S., with LatAm holding the largest valuation gap.
How are EM countries weathering the latest developments in the COVID-19 crisis?
Ribeiro: It’s no secret that COVID has been a disruptive force in all markets. But we think this, too, shall pass. While the Delta variant and recent spikes have renewed concerns, we expect subsequent surges of the virus to be temporary speed bumps, rather than permanent roadblocks to recovery.
Certain countries will likely see their 2021 GDP growth forecasts revised lower. But we expect such revisions to be minor, accounting for lowered mobility and the impact on domestic demand and consumption. We think this will delay growth, not eliminate it. And we expect to see most of this growth return in 2022.
What should investors take away from the recent volatility in emerging markets?
Ribeiro: We believe recent short-term volatility has created opportunities for long-term investors as various headwinds become less problematic. Regulatory changes will likely continue in China, but the worst of them is likely behind us. We also think emerging markets could start to perform better through year-end and into 2022 as vaccination procurement and administration continue to improve.