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Terms and conditions for Canada

by  Richard Farrell Sep 24, 2020

COVID-19 in emerging markets

Over the past 20 years, emerging-markets equities have gone from being dominated by Latin America and commodity producers to being driven by North Asia and technology. China now makes up over 40% of the MSCI Emerging Markets Index and China, Taiwan and South Korea together account for two-thirds of the benchmark. The “internet enabled” sectors of Information Technology, Consumer Discretionary (e.g. Alibaba) and Communication Services (e.g. Tencent) represent just under 50% of the index, while sectors historically associated with emerging-market equities, namely Energy, Materials and Industrials, now account for less than 20%. North Asian ‘Internet enabled’ stocks will be the key drivers of emerging-market equities over the next 12 months.

Latin American countries have been particularly affected by the COVID-19 pandemic. However, the emerging-market countries with the three largest stock markets – China, Taiwan and South Korea – have had relatively low infection and death rates compared with the global average. They also avoided the blanket nationwide lockdowns seen in Europe and suffered less economic pain. On a market capitalization-weighted basis, emerging markets as a whole have had a much lower infection rate than the U.S.

Recent emerging-market performance

From the start of the year until the end of August, and in line with developed-market equities, the emerging-market equity benchmark had recovered almost all of its recent losses, and was down only 0.5%. Excluding China, emerging-market equities were down 11% during the same period, reflecting China’s strong performance on the way into and out of the pandemic-driven correction.

So far this year, China, Taiwan and South Korea are the three strongest performers, with the China and Taiwan indexes both up over 10% so far this year. The weakest markets have been Latin American ones most affected by COVID-19 and Russia, which was hurt by a drop in the oil price. Predictably, North Asian currencies have significantly outperformed those in Latin America, Eastern Europe, the Middle East and Africa. Brazil, South Africa, Russia, Mexico and Turkey all have all had large currency depreciations this year, reflecting their exposure to commodities, weak current-account balances, or both.

Performance is being driven by trends similar to those witnessed in developed markets, namely the strong performance of the Information Technology, Consumer Discretionary and Communication Services sectors, with all three up over 15% so far this year. The Health Care sector is another strong performer, up over 30% so far this year, but it makes up only 4.3% of the emerging-market index.

Current valuations

Given the rebound in emerging-market equities, the index is now at its 20-year median level based on price-to-book values, but is near a historically low discount of 36% relative to developed markets. Divergences in country and sector valuations are at an all-time high within emerging markets, reflecting the issues highlighted above. Markets in China and Taiwan, even with relatively strong performances, are only slightly above their long-term median valuations, while South Korea is below its median.

On a sector basis, the price-to-book valuation divergence is more extreme, with Health Care and Consumer Discretionary near 20-year highs and Energy and Financials at long-term lows. The Information Technology sector, even with its strong year-to-date performance, rests just below its 20-year median.

The preceding valuation analysis prompts us to pose the question: are we starting to see a bubble form in parts of the emerging-market universe, particularly in China? While the price-to-book ratio for the Chinese equity market is only slightly above its 20-year median, some sectors look stretched, even when using a 2021 price-to-earnings multiple. The multiple for the Health Care sector has risen to about 38 times next year’s earnings from 21, and some individual companies look overvalued. However, the Health Care sector makes up only 5.5% of the Chinese stock index. In contrast, valuations in Financials have continued to fall and the sector now trades at 5.6 times next year’s earnings. Financials makes up a relatively large 14.6% of the Chinese index. There are parts of the market that look overvalued, but they are concentrated in technology and the smaller Health Care sector.

MSCI Emerging Markets Index Equilibrium

Normalized earnings and valuations

MSCI Emerging Markets Index Equilibrium

Note: Fair value estimates are for illustrative purposes only. The bands’ boundaries capture one standard deviation of movement above and below this estimate. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks. It is not possible to invest directly in an unmanaged index. Source: RBC GAM

12-month outlook and the U.S. dollar

Equity markets seem to be pricing in low growth and inflation over the next decade. As a result, emerging-market equities can continue to rise given historically low foreign-exchange levels versus the U.S. dollar and relatively cheap equities, as ultra-loose monetary policy in developed markets will pull down the discount rate for ‘internet enabled’ growth stocks. If growth and inflation do not pick up, China, South Korea and Taiwan will likely drive the market over the next 12 months. However, if the unprecedented fiscal and money stimulus in the U.S., Europe and Japan results in an economic-growth rebound and higher inflation expectations, we could see a sharp rotation in the relative performance of asset classes, regions and styles.

A strong rebound in global growth with a weaker U.S. dollar would likely result in strong emerging-market outperformance. Moreover, an increase in inflation expectations, and thus U.S. interest rates, has historically benefited emerging-market value stocks over growth stocks, and could point to a preference for value stocks after an almost 10-year period during which growth has been in favour.

Does recent weakness in the U.S. dollar portend to a change in market expectations around growth and inflation? If it does, Latin America, Eastern Europe, the Middle East and Africa would likely outperform given their exposure to value sectors such as Energy, Materials and, to a lesser degree, Financials.

Conclusion

The recent performance of emerging-market equities has represented a continuation of the trends that we have seen in recent years. ‘Internet enabled’ growth stocks continue to outperform, benefiting countries and sectors most exposed to this area. This trend in style, country and sector performance has only accelerated during the pandemic.

Over the next 12 months, these trends will likely persist if markets continue to price in low global growth and inflation. However, the unprecedented fiscal and monetary stimulus in the U.S. means that the supply of U.S. dollars is expanding at double the rate of any other major economy. We would expect this to lead to a continued weakening of the U.S. dollar.

A weak U.S. dollar often signals the outperformance of emerging-market equities, given their historical relationship to the U.S. dollar and economic growth. The risk for us, managing money relative to a benchmark, is that this could lead to a style rotation where value starts to outperform. We therefore believe a barbell-type portfolio that avoids the most expensive growth stocks and offers exposure to higher-quality value companies is most appropriate to manage this risk.

Discover more insights from this quarter's Global Investment Outlook.

Disclosure

This document is provided by RBC Global Asset Management (RBC GAM) for informational purposes only and may not be reproduced, distributed or published without the written consent of RBC GAM or its affiliated entities listed herein. This document does not constitute an offer or a solicitation to buy or to sell any security, product or service in any jurisdiction; nor is it intended to provide investment, financial, legal, accounting, tax, or other advice and such information should not be relied or acted upon for providing such advice. This document is not available for distribution to people in jurisdictions where such distribution would be prohibited.

RBC GAM is the asset management division of Royal Bank of Canada (RBC) which includes RBC Global Asset Management Inc., RBC Global Asset Management (U.S.) Inc., RBC Global Asset Management (UK) Limited, RBC Global Asset Management (Asia) Limited, and BlueBay Asset Management LLP, which are separate, but affiliated subsidiaries of RBC.

In Canada, this document is provided by RBC Global Asset Management Inc. (including PH&N Institutional) which is regulated by each provincial and territorial securities commission with which it is registered. In the United States, this document is provided by RBC Global Asset Management (U.S.) Inc., a federally registered investment adviser. In Europe this document is provided by RBC Global Asset Management (UK) Limited, which is authorised and regulated by the UK Financial Conduct Authority. In Asia, this document is provided by RBC Global Asset Management (Asia) Limited, which is registered with the Securities and Futures Commission (SFC) in Hong Kong.

Additional information about RBC GAM may be found at www.rbcgam.com.

This document has not been reviewed by, and is not registered with any securities or other regulatory authority, and may, where appropriate, be distributed by the above-listed entities in their respective jurisdictions.

Any investment and economic outlook information contained in this document has been compiled by RBC GAM from various sources. Information obtained from third parties is believed to be reliable, but no representation or warranty, express or implied, is made by RBC GAM, its affiliates or any other person as to its accuracy, completeness or correctness. RBC GAM and its affiliates assume no responsibility for any errors or omissions.

Opinions contained herein reflect the judgment and thought leadership of RBC GAM and are subject to change at any time. Such opinions are for informational purposes only and are not intended to be investment or financial advice and should not be relied or acted upon for providing such advice. RBC GAM does not undertake any obligation or responsibility to update such opinions.

RBC GAM reserves the right at any time and without notice to change, amend or cease publication of this information.

Past performance is not indicative of future results. With all investments there is a risk of loss of all or a portion of the amount invested. Where return estimates are shown, these are provided for illustrative purposes only and should not be construed as a prediction of returns; actual returns may be higher or lower than those shown and may vary substantially, especially over shorter time periods. It is not possible to invest directly in an index.

Some of the statements contained in this document may be considered forward-looking statements which provide current expectations or forecasts of future results or events. Forward-looking statements are not guarantees of future performance or events and involve risks and uncertainties. Do not place undue reliance on these statements because actual results or events may differ materially from those described in such forward-looking statements as a result of various factors. Before making any investment decisions, we encourage you to consider all relevant factors carefully.

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© RBC Global Asset Management Inc. 2020
Publication date: (September 15, 2020)