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The prospect of a coronavirus vaccine has a more powerful impact on emerging market economies because they lack the domestic infrastructure to deal with the pandemic.Manjurul/iStockPhoto / Getty Images

Emerging markets are making a comeback after a drubbing from the COVID-19 pandemic and a nasty trade war.

The benchmark MSCI Emerging Markets Index is up by more than 10 per cent since late October, when it became clear now-president-elect Joe Biden would win the U.S. presidential election and a coronavirus vaccine would begin circulating in the new year.

The index bottomed out in March, losing over one-third of its value since U.S. President Donald Trump’s “America First” trade war ramped up in January, 2018. In the preceding three months before the March bottom, it fell by more than 25 per cent as the economic fallout from COVID-19 took hold.

Institutional investors are taking the cue. The latest monthly survey of 190 global fund managers overseeing a combined US$526-billion in assets by Bank of America Corp. identified a sharp rotation into emerging-markets equities.

“We don’t think this is over. We think this is a trade that can continue,” says Matthew Strauss, vice-president, portfolio management, and portfolio manager, at Signature Global Asset Management, a division of CI Global Asset Management, who manages several emerging-market investment funds.

He says the capital flow to emerging markets is a response to the political shift from Mr. Trump’s anti-globalization trade policies to Mr. Biden’s foreign-policy experience gained from two terms as U.S. vice-president under Barack Obama.

“You’re suddenly bringing in a very experienced foreign-policy practitioner. You’re bringing in more predictable policies,” Mr. Strauss says.

Furthermore, the prospect of a vaccine has a more powerful impact on emerging-market economies because they lack the domestic infrastructure to deal with the pandemic, he says.

“[These economies] do not have the same fiscal depth and flexibility as developed markets, and they cannot use monetary policy as aggressively as developed markets,” Mr. Strauss says. “They are generally far behind the health care capabilities and capacity of developed markets, so a vaccine is much more essential for these countries to get back on track.”

Even within emerging markets, he says investment potential is rotating from more established economies including China, Taiwan and South Korea to Latin America, Eastern Europe, the Middle East and parts of Africa.

“We think the Middle East, and especially Latin America, offer really good opportunities because they have underperformed so significantly, and valuation-wise they’re significantly cheaper regions,” he says.

However, Mr. Strauss cautions the less established emerging markets are short-term opportunities and prospects for longer-term growth are greater in the established emerging markets.

“We still think the outperformer will be Asia, led by China,” he says.

In terms of sectors, he’s been trimming stronger-performing stocks led by the “stay at home” theme during the pandemic, such as technology and consumer discretionary – specifically e-commerce and food delivery.

“We are currently underweight on the technology side. In the meantime, we have increased more on financials, energy and materials. It’s more of a shift to the sectors that we feel will benefit from a cyclical recovery,” he says.

It’s not easy for retail investors to access emerging markets directly. Although there are several actively managed mutual funds that focus on this space, returns can be diminished by annual fees typically in the 2-per-cent to 3-per-cent range.

A less expensive option is passively managed exchange-traded funds (ETFs) that track the MSCI Emerging Markets Index or specific indexes such as India’s Sensex or Hong Kong’s Hang Seng.

But ETFs can’t always capture the full upside of emerging markets because they tend to be more dynamic than developed markets, says Greg Taylor, chief investment officer at Purpose Investments Inc.

“You want to make sure you are looking at the companies underlying the index and getting access to them,” he says, adding that passive emerging-market ETFs often overlook the levels of government ownership in the larger companies.

“When you’re looking at emerging markets, you have to do some fundamental work because a lot of the big companies in these indexes are basically government enterprises,” Mr. Taylor says.

Purpose Emerging Markets Dividend Fund (REM-NE) relies on subadvisors on the ground in emerging markets to not only find stocks at low prices, but companies that pay dividends. The ETF currently pays an annual dividend of about 4 per cent.

“It’s a good way to get exposure for a lot of themes we’re looking for in 2021, which is both emerging markets coming back with global growth, but also more of an emphasis on dividends,” he says.

Emerging markets are generally skewed toward commodities and cyclicals. As such, Mr. Taylor says the best value is in resources such as copper, which is also known as an accurate indicator of the health of the broader economy. The price of copper increased by more than 10 per cent in November.

“Copper seems to be going hand in hand with emerging markets,” he says, adding that a normalized supply chain will release pent-up demand.

“When you get a normalization and people start to trade more and use more goods, that’s good for commodities. It’s also good for emerging markets, which are still thought of as a manufacturing base for the world,” Mr. Taylor says.

Nevertheless, he says the best long-term growth potential for emerging markets is in Asia-based technology manufacturing.

“We still like the Asian markets as that’s the area that’s going to show the best growth,” he says.

As an added bonus, a weaker U.S. dollar is providing more buying power for Canadians investing in Canadian dollars outside of Canada, and emerging-market companies that rely on U.S. suppliers. Mr. Taylor expects that trend to continue.

“We could see the U.S. dollar stay under pressure. Emerging market and other currencies should start to outperform the U.S. dollar, so you would see a benefit from that,” he says.

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