In a low-growth environment, investors, facing limited choices, are willing to pay top dollar for growth stories. The US equity markets are the go-to stops for growth prospectors looking for the next Amazon or Apple. With its large consumer base, and deep and liquid capital markets, there has traditionally been no better place than the “land of opportunity” for companies, especially tech names, to make it big.
But with the US grappling with the Covid-19 pandemic amid a more uncertain global environment, investors are looking elsewhere for growth opportunities. In the fixed income space too, near-zero US interest rates have nudged yield-seeking investors to look elsewhere for alternatives to “safe-haven” US treasury bonds. Now, with significant growth potential yet offering relatively higher credit yields, emerging markets (EMs) — especially those in Asia — have become particularly attractive to investors.
Typically, EM assets are perceived as riskier than developed market (DM) assets, but ChiaLiang Lian, head of emerging markets debt at Western Asset Management, sees this changing. In the EM debt space, says Lian, investmentgrade bonds now make up close to 60% of the asset class. This suggests that EM assets are becoming mainstream rather than an “exotic allocation”.
Manraj Sekhon, chief investment officer of Franklin Templeton emerging markets equity, remarks that EM equity performance year-todate (YTD) has been “highly credible” amid a difficult pandemic year. He highlights that China, in particular, has proven to be a safe haven as it emerges swiftly from Covid-19 lockdown.
“I think if we were sitting here back in February, very few people around the world ... would have predicted that ... Asia as a whole would have outperformed the US,” says Sekhon. That EMs have fared better than many DMs in grappling with Covid-19 not only speaks to the resilience of their socio-economic regimes; it is also their embrace of the digital economy, allowing them to regain some semblance of economic normalcy more quickly, he adds. Within the EM universe, the dynamic economies of East Asia will be better prepared for the post-Covid economy and leapfrog less well-adapted business models elsewhere, says Sekhon.
Lian observes that as a sign of growing popularity, short-term “tourist” flows into EM debt are being displaced by long-term institutional investment. A survey of institutional investors by Vontobel Asset Management found that 57% of institutional investors in Asia Pacific expect higher EM allocations over the next five years.
That said, the defining feature of EM assets is their diversity, note Lian and Sekhon. While some EMs like China have performed so well that they could be included in a class of their own between EMs and DMs, others such as Brazil are struggling with a weakened currency and runaway Covid-19 infections.
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Happy new year for EMs
Heading into the new year, 2021 looks to be a promising one for EM debt. With strong growth in these economies coupled with a global economic rebound, Lian sees EM growth putting an upside on the price of EM credit due to the sheer amount of pent-up demand that was present in early 2020 when growth took a hit. With the global economy having bottomed out in 2Q2020 and now experiencing a technical recovery, he sees EMs outperforming DMs going forward.
The International Monetary Fund projects that China will grow by 8.2% next year. If so, this will mark the fastest pace of expansion under the watch of President Xi Jinping. Naturally, strong Chinese economic performance will be highly beneficial for EM debt. Beijing is committing to further financial liberalisation, which means investors, wary of a weakening US dollar, will be happy for the chance to gain more exposure to renminbi-denominated Chinese government bonds and other Chinese credit. Lian recommends state-owned entity bonds and other high-quality credits.
Better yet, much of this strong growth potential can be obtained at attractive valuations. With inflation expected to stay relatively low as economies take time to close the output gap, Lian believes that the resulting low inflation will drive a “search for yield” in an investing environment where low credit yields have become a norm. EM credit will therefore be viewed as an attractive proposition as they are relatively cheap vis-a-vis DM counterparts, with ‘A’- rated EM credits trading wide of DM peers by approximately 70-80 basis points.
That said, Lian observes that the last three to five years have been difficult for EM credit from a technical standpoint. The asset class struggled from weak commodity prices and idiosyncratic risks, especially in Latin America. “We do think that as an asset class it is under-allocated. When you look at some of the published flows into EMs, hard currency bonds inflows in the year to date are about a fraction of last year’s inflows,” he acknowledges, with weak ‘B’-rated countries and lower-rated highyield credit potentially at higher risk of default and restructuring.
In the equity space, Sekhon sees traditional growth businesses performing strongly in a very low growth environment where risk premiums have collapsed; meanwhile, traditional value has seen growth visibility and earnings collapse totally. “The delta between traditional growth and traditional value is so huge that any positive news of normalcy ... is going to bring about a huge shift,” he explains.
A long period of traditional value underperformance, exacerbated by Covid-19, has caused earnings visibility to collapse, resulting in rock-bottom valuations and smaller market capitalisation of these businesses. Accordingly, says Sekhon, capital flows into these traditional value stocks will bring about share price movements disproportionate to the rest of the market.
“We are of the view that a simple rotation away from so-called traditional growth [into] traditional value is not going to be a sustainable approach in the face of a vaccine, or indeed any herd immunity or normalcy,” says Sekhon. He sees growth remaining low as large chunks of the economy — particularly in the West — struggle to recover. Growth visibility is thus crucial for investors, with Sekhon preferring business models with the resilience and adaptability to thrive in the future economy while avoiding those vulnerable to disruption.
China’s tech sector is a potentially potent wellspring of growth. “Over the next few years, the opportunities we see in China which are distinct, are really in the new economy, consumer-facing digital space,” says Sekhon. For example, the likes of Ant Finance, Alibaba and Tencent are spearheading innovation not seen in the West, much less the rest of the world. He urges investors to get on the ground and intimately learn how China’s distinct tech ecosystem operates to better understand these businesses.
See: Emerging market investors sanguine about US election outcome
Uncle Sam resurgent
Yet despite the growing interest in EMs, Wall Street continues to be seen as the “Premier League” of growth investing. In an audience poll at the Franklin Templeton webinar, slightly more than half of the attendees indicated that US equities were the most likely asset class to yield the highest returns in 2021 in a field including EM equities, EM debt and global government bonds. EM equities came in a somewhat distant second.
Grant Bowers, portfolio manager at Franklin Equity Group, says that despite a large number of US Covid-19 cases, economic indicators are improving. Since 2Q2020, the US job market has been improving and the GDP impact moderating. Corporate earnings and margins are also recovering. He sees US recovery accelerating in 2021 albeit unevenly, with GDP growth in 1Q2021 seen to be 3-5%, and some acceleration from there primarily from pentup demand.
Consequently, US equity markets have performed, as investors believe that the worst of the pandemic is over. A recent breakthrough in the development of a Pfizer-BioNTech Covid19 vaccine — which claims an efficacy rate of 90% — and two other vaccines has only brought more cheer to Wall Street. “Any true vaccine or therapy is ultimately going to be a game-changer,” adds Bower, with any further success likely to prove a shot in the arm for US stocks.
An unprecedented level of fiscal and monetary response pursued by the US government targeting consumers has been positive for investor confidence, especially with the Federal Reserve’s assurances that it would do “whatever it takes” to protect the US economy. Democratic candidate Joe Biden’s victory, likely accompanied by a split Congress, will ward off destabilising policy changes, though the US-China trade conflict will likely be an unavoidable long-term reality.
Bowers warns that very sharp retrenchment in the US is likely to change US consumption patterns as consumers reconsider their spending priorities. Yet, a wave of de-urbanisation is also taking place across the US, strengthening the housing market in the process. Housing typically exerts a multiplier effect on the US economy, says Bowers, as new households are formed in the suburbs to fuel greater household expenditure.
Therefore, Bowers is “looking through” the pandemic and positioning to capitalise growth on the upside while providing portfolio balance in 2021. “We are focusing on highquality growth franchises, looking at businesses that are not just growing, but also driving and leveraging innovation that we think will continue to lead this market,” he declares, predicting that growth rather than value will lead on Wall Street. Long-held growth themes like FinTech/payment, healthcare innovation, cloud computing and mobility/5G remain promising.
Some older investors may fear that ebullience on the tech sector is a harbinger of another dotcom bubble. But Bowers says that present optimism does not so much reflect irrational exuberance as excellent market fundamentals. Yes, valuations are high, but that is justified by the role of these tech companies in driving overall efficiency and cutting costs.
“Tech brings probably the fastest growth in the overall market, the most consistent growth, the highest levels of cash flows, the highest margins [and] the broadest diversified international revenue streams ... and I think it brings a lot of visibility,” Bowers assures investors.
