Regina Chi is vice-president and portfolio manager of AGF Investments Inc.
As the COVID-19 environment endures, uncertainty has crept back into the capital markets. Meanwhile, the human toll has been grim. So has the economic one. Both could well get worse.
This ever-changing reality makes it difficult for investors to look beyond the pandemic to whatever the new normal will be when and if it recedes. Yet there are still some secular trends that the pandemic has not disrupted. In the context of emerging markets (EM), one of the most important is deglobalization. As economies regionalize and localize, independent country returns are becoming more uncorrelated with each other – and investors who still look at emerging markets as a single, unified asset class need to rethink their approach.
The pace of globalization has ebbed and flowed over the years. The most recent upswing, which can be roughly pegged to China’s accession to the World Trade Organization in 2001, was remarkable in its speed and degree. Yet the tide now seems to have turned. Measures of trade openness – for instance, exports and imports as a percentage of GDP in a basket of representative countries – have been declining since 2017, according to UBS research published in June.
We believe this is occurring for three primary reasons. The most obvious is the increase in trade tensions and protectionist measures among many countries. The tech war between the U.S. and China has been grabbing headlines recently but in fact, on a global basis, protectionist measures affecting trade in goods have been far outpacing liberalizing measures for the past decade, according to UBS. Another factor: technological shifts. In the era of smartphones and 3-D printing, the relative advantage of outsourcing manufacturing has declined; so, too, has the value of imported technology to emerging markets. And finally, many emerging-market outsourcing destinations are maturing. Chief among them is China, whose labour and environmental cost advantages have declined rapidly throughout the past decade, while trade policy risk has increased.
This trend started long before COVID, but the COVID environment is likely to only accelerate it. The pandemic has disrupted global supply chains, which might well fall into permanent reorientation. In this evolving world, China still looms large, but multinational corporations will be ever more likely to diversify their supply chains and adopt “China-plus” strategies to mitigate policy risk and lower costs.
The most important takeaway is that emerging markets can no longer be viewed as a homogeneous asset class. There are 26 countries in the MSCI Emerging Markets Index, and their differences from each other will increasingly become more important than their similarities as developing economies.
For investors, the goal then becomes identifying outperformers on a country basis. How do we do that? One important step is to recognize the idiosyncrasies of many EMs. One is that GDP growth is generally very weakly correlated with stock market performance in emerging markets. Brazil’s GDP growth barely beat 1 per cent last year, but the Bovespa Index gained 27 per cent, according to Bloomberg data; meanwhile, Indonesia’s economy grew by 5 per cent in 2019, but its stock market returned only 10 per cent, underperforming the MSCI Emerging Markets Index. This weak correlation reflects the fact that EM stock markets often only weakly mirror the composition of the country’s real economy.
Another idiosyncrasy about EMs: Currency matters – a lot. EM currencies are generally more volatile than those of developed countries, in part because many rely heavily on foreign-denominated – especially U.S.-denominated – debt. Those with stronger current accounts, and therefore relatively stronger currencies, are better insulated from developed economy monetary trends, and over the long term their stock markets tend to outperform other EM countries with weaker current accounts. That’s why one of the factors we pay very close attention to is current account-to-GDP.
One country that pops up in our analysis is Taiwan. While not immune to the uncertain global demand backdrop, the country is bolstered by a strong balance of payments and steady pace of economic and earnings recovery. In part, this is owing to its strong COVID-19 response relative to the emerging markets universe, but with almost 28 per cent of total exports to China, it also helps that Taiwan has benefited from its largest trading partner’s sharp V-shaped recovery. For example, one of our top 10 holdings, Taiwan Semiconductor Manufacturing Co. (TSM-NYSE), is the world’s largest outsourced “foundry” of semiconductor chips. It is a significant beneficiary of secular drivers such as artificial intelligence and fifth-generation (5G) applications, and it stands to benefit from Intel Corp.’s recent struggles.
We are not in any way calling the end of globalization: It is far too late to put that genie back into the bottle. As it has ebbed and flowed in the past, we think it has just receded given each country’s own national policies. In the meantime, a more regionalized and localized landscape is evolving. This evolution will increasingly challenge traditional approaches to emerging markets, but it will also present investors with new opportunities – if they know where and how to look for them.
AGF owns stock in Taiwan Semiconductor Manufacturing Co.
The views expressed are those of the author and do not necessarily represent the opinions of AGF, its subsidiaries or any of its affiliated companies, funds or investment strategies. References to specific securities should not be considered as investment advice or recommendations.
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