In this webinar, Laurence Bensafi, Deputy Head of Emerging Markets Equity, and Zeena Dahdaleh, Portfolio Manager, RBC Global Asset Management (UK) Limited cover several topics, including:
- The latest developments across emerging markets economies, currencies and equity markets in light of the coronavirus pandemic, and in the context of previous crises.
- How the pandemic has changed consumer behaviour, and whether there is still a case for the Domestic Consumption theme in the future.
Watch time: 18 minutes 03 seconds
I’m going to talk you through our outlook for emerging market equities for the rest of the year, and hand over to Zeena. She is going to talk about the impact of the virus on the consumers in emerging markets.
So, it is a surprise to many that equity markets around the world have rebounded so quickly since the 23rd of March of this year. Right now, the S&P 500 is pretty much flat for the year, and the NASDAQ is actually up close to 8%. This is incredible, considering we are still in the middle of the worst global recession since the Great Depression almost 100 years ago. There are several reasons for that. One is the lack of attraction of the bond market right now. Second, it seems that the pandemic is maybe much more short-lived than anticipated earlier this year.
It is however interesting to note that emerging market equities have really lagged developed market equities in the rebound. This is unusual as emerging markets usually is a high-beater asset class, and should have done better. What we have right now is emerging market equities down 8%, 9% for the year. That is pretty much 10% under the performance to the developed markets. So why? Several reasons. One of them is that a lot of the biggest countries in emerging markets, namely Brazil, India, South Africa, Mexico, seem to be behind the curve when it comes to tackling the virus. It is not clear if these countries have seen the peak of infection or not yet.
Another reason is the U.S. dollar has been very strong, quite resilient, until very recently. And in a world where deficits and debt levels are increasing, that has caused issues for some of our emerging market countries, notably the ones with a large current account deficit.
At this point in the rebound, we have been really in a risk-off environment, as we saw with the lead of growth stocks over value stocks. In order to see emerging market equities perform better, we need to be in a more risk-on environment.
However, we think that in the coming months, emerging markets could well out-perform developed markets. Why that? First, we feel that the worst of the pandemic is behind us. Pretty much all countries in the world seem to follow the same train as in North Asia, Europe and the U.S. They may have just been a bit late to hit the peak, but we should see Brazil and India peaking in the coming weeks. That will be very positive for our markets.
The U.S. dollar is starting to weaken quite quickly from an overvalued level, created by a flight to safety during the worst of the pandemic. As the dollar starts to weaken, many emerging market currencies are appreciating adding significantly to returns. Another reason could be the growth differential. The chart you can see here shows there is a very strong correlation between the difference of performance of emerging markets versus developed markets on the equity market, and a differential of GDP growth for the two asset classes. If you look at the charts, you can see that we can understand very well the underperformance of emerging markets for the past 10 years, as the growth differential collapsed from about 8%, to about 2%.
However, if you look at what we should see for 2020 on the following charts, it is a completely different picture. According to the IMF’s latest numbers, which I assume will be updated in the coming months, we should see actually a much stronger resilience of emerging markets versus developed markets. Those numbers from the IMF, emerging markets are going to drop only about 1%, when we expect about a 6% drop for developed markets. So it means that the differential of GDP growth will increase in 2020, and that should mean an outperformance for emerging markets. Especially as valuation arrived, emerging market show the largest cut to developed market at about 35% right now, compared to an average of about 10% over the long-term.
Looking elsewhere, we are looking at the best opportunities for emerging market equities, in terms of countries. This chart shows you the performance, year-to-date, for some of our countries. You can see there is a large dispersion since the beginning of the year. At the top, you can see the countries which have been the most resilient when it comes to the virus. China, Taiwan, Korea - where the virus seems to be really under control - have performed the best. On the other hand, the countries I mentioned earlier have been the worst performing. As I also mentioned earlier, they should start to do better as the virus seems to be under control in those countries in the coming week.
Looking at valuation for those countries, on the following chart, we can see that, again, there is a large dispersion in valuation. Some of the countries, namely Mexico, Chile, Turkey and Korea, are the cheapest they have ever been, and are looking really attractive. On the other hand, countries such as Taiwan does not appear as cheap, and we would be cautious, notably when it comes to domestic names in the country.
Looking at opportunities in terms of sector, in this chart you also see a very large dispersion of returns. Healthcare, communication services, are actually up for the year. They have been the big winners during the pandemic. On the other hand, energy and financial have been really lagging. Looking at valuation now on the following chart, you can see again that energy and financial are the cheapest they have ever been. We are quite positive on financials, notably on the banks. On the other hand, when it comes to energy, as the oil price has already rebounded to about $40 dollars, we would be a little bit more cautious going forward.
Finally, on FX. This is really important to look at FX for emerging markets, because up to 70% of returns can come from your exposure to currencies. Again, we have seen really large dispersion. You can see at the bottom performers have been the Brazilian real, and the South African rand. When it comes to valuation, you can see on the chart, on the x-axis, our cheapest currency compared to other currencies. On the y-axis, the cheaper the currency compared to history. Again you can see, very attractive currency here. One we would highlight as very attractive right now is the Chilean peso. Chile is a country which has strong, stable structure, which we really like. On the other end, we will be a little more cautious about Turkey, the Turkish lira, and the South African rand, where we have structural issues within those countries.
In conclusion, emerging market equities have lagged in rebound, and if we don’t see any second wave of the virus in the coming weeks or months, we should see a catch up with developed markets. As the U.S. dollar continues to depreciate, and laggards rebound. However, challenges remain for the asset class. Volatility may remain high in the coming months.
I am going to now hand over to Zeena. She is going to talk about the impact of the virus onto consumers in emerging market countries.
Thanks Laurence. Domestic consumption has been an important theme for emerging markets in our portfolio over the past decade. History, if anything has taught us, that crises can lead to long-lasting changes, and fundamentally change consumer behaviour.
During World War II, women were encouraged to fulfill domestic jobs, and then after the war, those shifts persisted, and we saw an increase in female participation in the workforce. Another example is in 2003, with the SARS outbreak in China, where we saw a permanent increase in online shopping.
In the next few minutes, I’m going to go through how we feel COVID-19 will structurally impact the domestic consumption theme, and the ways were playing the theme in our portfolios.
In the past, when we spoke about domestic consumption, some of the strongest drivers behind the theme were the rising emerging market middle class, increased incomes, positive reform momentum, low household leverage, digital, population growth, and urbanization.
In a post-COVID-19 world, the key question we’re asking ourselves is, is the theme still intact, and which of the factors are supportive? Having analyzed all the factors I just mentioned, the conclusion we have come to is that in the nearer term, we are likely to see the emerging middle class consumption story stall, due to the weaker macro backdrop.
If you look at the chart on the left-hand side, you can see that GDP growth expectations, and GDP per capita in emerging markets for 2020, has come down. Now, although we not sure yet of the real impact on disposable income, we do feel that we’re unlikely to see a real wage growth in emerging markets for 2020. Having said that, disposable income is cyclical, and we still think the longer term structural story for consumption in emerging markets still holds, and it’s based on the following factors.
First of all, reforms. This crisis, if anything, has allowed reforms to focus on two key areas, such as transport and the healthcare space. We’ve also seen reforms implemented to boost domestic consumption. Specifically in China, we’ve seen subsidies for large-ticket items, and we expect to see similar policies implemented elsewhere in our universe.
Second of all, population growth. The UN estimates that by 2030, global population will reach 8.5 billion, and 97% of that population growth will come from emerging markets. More interestingly, two demographic groups in emerging markets which will be very relevant for consumption trends are Millennials and Generation Z. As you can see from the chart on the right-hand side, these represent nearly 50% of the emerging market population.
Thirdly, urbanization. Although we acknowledge that the working from home experiment has been successful, and could be an argument for a slowdown in urbanization, we think this is very much a developed market phenomenon, and that emerging market urbanization still has a long way to go, particularly in regions such as Latin America and Africa.
Fourthly, household leverage. Historically, we have seen credit and access to credit being the key driver to consumption growth in emerging markets. Now although we have seen consumer credit grow over the past decade, household leverage still remains low.
Finally, digital. The evolution of online retail has added convenience and accelerated the pace of consumption in emerging markets, and this pandemic will accelerate that migration online.
So the next key question is, what are the key way to play this theme in emerging markets? The most relevant one that we’ve identified is online retail. Not surprisingly, we’ve see store closures and lockdowns incentivize new online users. Now while some of these consumers may return to physical formats and the brick-and-mortar businesses, we do feel that a lot of these new users will stay online.
As I mentioned earlier, we saw this with SARS in 2003 in China. We really expect this trend to be relevant, especially in countries such as Brazil and Mexico, where digital buyer penetration remains really low. You can see that from this chart here.
The second way to play the theme is through modern retail penetration. Over the past few years we have seen a gradual decline in traditional trades, so mom-and-pop stores, and increasing relevance of modern trade. This is due to a variety of factors – from urbanization, to a more appealing store layout, to more convenient ways of payment, to a wider range of SKUs. We expect this pandemic to accelerate this trend even further. Generally, modern trade retailers have stronger balance sheets, and have been much more efficient at managing the supply chain disruption that we’ve seen as a result of the pandemic.
One of the debates that is becoming a lot more relevant within the onset of the pandemic is whether increased online retail will negatively impact physical store performance within the modern trade channel.
We believe consumers today in emerging markets make purchasing decisions based on needs, rather than the channel type. So they don’t mind using multiple channels, and alternating between the physical stores and online stores. So we think physical stores will compliment any structural increase in online retail we expect to see in the food space.
We also believe emerging markets are likely to go down a slightly different route to what we’ve seen in the developed world, where we have seen the emergence of pure online food retailers. There’s a few reasons behind this.
First of all, smaller basket sizes. Disposable income in emerging markets is lower than what we’ve seen in the developed world, and average basket size has been significantly lower than the level needed to break even for this pure online food retail model to work.
Secondly, the stage of retail development in emerging markets. We’re still relatively behind the developed world. If we just look at China, as you can see from the chart on the left-hand side, traditional retail still represents 60% of total food sales.
Thirdly, delivery times. Traffic congestion in most emerging markets cities is still an issue, and it’s really hard to set up one large fulfillment centre for this model to work. Therefore, physical stores are needed for distribution.
The third was to play the domestic consumption theme is through health and wellness related products. Health and wellness is becoming more and more important in emerging markets, and we actually think, if anything, the pandemic will increase that pace of this trend for a few reasons.
First of all, this crisis has shown us that there is a mismatch between funding expectations and reality within the health care space. We think as a result of this pandemic, emerging market public expenditure in health care has no choice but to increase.
Second of all, we all know that obesity is a problem in emerging markets. Just as a reminder, China and India represent 50% of the world’s obese, and we think this issue has come further to light, just because of the fact that evidence shows that obesity-related conditions can worsen the impact of the virus.
We’ve also seen an increase in digitalization of health and wellness related services, from telemedicine to online gyms. This has increased awareness of consumers, regarding purchasing health and wellness related products.
The CTR Market Research Survey conducted in China shows that a large portion of consumers in China will continue to use services such as online hospital and interactive fitness after COVID-19.
The fourth way to play the domestic consumption theme is through premium products. So although down trading is inevitable in the shorter term for certain items, we think we will still see premiumization within certain categories, namely organic and fresh food, and personal care products. Within the food space, it was clear from a Nielson survey conducted in April on Chinese consumers that healthy eating and organic and fresh food will become more of a priority after the pandemic. You can see that from the chart on the left-hand side.
On the personal care side, we’ve seen super premium growth in the facial care and personal care space over the past few years, and again we expect this trend to continue.
The fifth and final way we’re playing domestic consumption in our portfolios is through local and sustainable brands. We believe local brands will continue to gain dominance over multinational brands. This has been the case for India in the personal care market, as you can see from the chart on the right-hand side. We expect this trend to continue going forward for a few key reasons.
First of all, increased nationalism. This has been especially the case in China, where we’ve seen an increasing nationalistic approach to local brands. In 2011, around 85% of consumers would have traditionally chosen multinational brands. Interestingly, as the result of this crisis, we’ve seen that switch, where now, around 85% of consumers actually want local brands.
The other key reason is the shortening of the supply chain. The disruption in supply chain has led to a preference for local supplies. We expect that shift to be permanent.
Finally, the other long-lasting implication of COVID-19 is the increasing focus on sustainable brands. This crisis has increased social awareness, and we have found increasingly that consumers are choosing brands that place the environment and society as key priorities. This is illustrated in the chart on the left-hand side.
So hopefully this gives you a good overview of how we’re thinking about the domestic consumption theme in a post-COVID-19 world, and some of the ways we’re playing the theme in the portfolio.