Top Ten Reasons Emerging Markets Poised to Rally in 2020
After false starts in the last few years, we believe emerging markets are set to deliver strong performance in the year to come, thanks to accelerating and broad-based drivers.
The stars have aligned for developing country and frontier markets as 2020 gets underway. Although a good number of factors are dovetailing to fuel emerging economies and companies in Asia, Latin America, Emerging Europe, the Middle East and Africa, we identify the top five technical and leading five structural dynamics that we see propelling returns in the asset class in the year ahead, and beyond.
1. The Greenback Takes a Break
For years following the 2008 Financial Crisis, U.S. benchmark interest rates were broadly expected to rise. While the U.S. Federal Reserve finally started hiking rates in late 2015, the key Fed funds rate plateaued at 2.5%. It started declining in mid-2019 and has leveled off at a modest 1.75%. Whatever the views on the necessity of the downshift, it clearly reduces policy support for the U.S. dollar. The change in the dollar’s outlook is important to dollar-based investors looking for opportunities overseas but who fear a loss of value due to local currency depreciation relative to the greenback.
Five-year Change in U.S. Dollar Value vs. Local Currency, as of 12/31/2019
2. Drop in Global Interest Rates
The dovish move in U.S. monetary policy takes pressure off many other central banks that were concerned about the impact of rising U.S. interest rates on their home currencies. In anticipation of tightening U.S. monetary policy, they had sought to offset the expected volatility by adopting highly restrictive monetary policies of their own. The tighter policy mitigated domestic currency weakness, which can lead to imported inflation and portfolio outflows to dollar-based assets. But the change in U.S. monetary policy, coupled with a benign inflation environment globally, has now created a backdrop in which we could see coordinated policy easing across most emerging markets in 2020.
10-Year Yield Change (basis points), as of 12/31/2019
3. Accelerating GDP Growth
After several years of slowing or sluggish growth driven by a combination of high interest rates, currency volatility, ebbing global trade and weak investment spending, the outlook is improving. Every major emerging market except China is expected to see faster economic growth in 2020 as the headwinds of the past few years abate and in some cases become tailwinds.
GDP Growth Acceleration (YoY), as of 12/31/2019
4. Faster Earnings Growth
After peaking in mid-2011, emerging market earnings consistently fell in U.S. dollar terms for nearly five years due to a combination of a stronger dollar and a painful reset of expectations, a process that took multiple years. Following a difficult start in 2016, the outlook brightened as global growth became positively synchronized, fueled by coordinated easing and Chinese economic stimulus. Unfortunately, this recovery was short-circuited by a new round of dollar strength resulting from the U.S.’s 2017 tax cuts and deregulation drive, which fueled a pick-up in U.S. growth. A softer dollar and faster emerging market growth should enable underlying earnings growth to shine through this time around. Earnings growth in most major emerging markets is expected to exceed the S&P 500 Index earnings growth in 2020.
Estimated 2020 Earnings Growth, as of 12/31/2019
5. Light Election Calendar
Election season presents a challenge to investment in most countries. But election risks are even more pronounced in emerging markets, where policy plays a key role in return projections and short-term capital allocation. Most developing countries see investment grind to a halt during election periods and the recent past was no exception. Starting with China’s virtually guaranteed leadership reinstatement in early 2018, multiple countries have held general elections: Indonesia, India, Mexico, Brazil, Argentina, South Africa, Colombia, Peru, and Thailand. Now that Taiwan has held its January 2020 vote, the election calendar overhang has lifted.
6. Structural Reform Benefits Kick In
Sometimes elections result in business-friendly regulatory changes that ultimately boost investment and earnings growth. India’s BJP, for example, won power in 2014 and was reelected in 2019. It has since streamlined a thicket of state tax regimes into a nationwide Goods and Services Tax (GST); introduced a badly needed Insolvency and Bankruptcy Code; and liberalized foreign direct investment rules. The changes were disruptive and painful but have paved the way for broader and more sustainable economic growth. Last year, Brazil pulled off a long-elusive reform of its pension system that should enhance fiscal stability and a deregulation package that cuts compliance costs and boosts the ease of doing business. China has decreased excess capacity in several industries; reigned in “shadow banking” (off-balance lending) as well as dicey wealth management products; and reduced value-added taxes. Such reforms have also taken place in many other smaller and mid-sized emerging markets.
7. Middle Class Emergence
Hundreds of millions of people in emerging markets have entered the middle class in recent years, and hundreds of millions more are joining their ranks. The Brookings Institution reckons the middle class in emerging economies could see yearly growth of 6%, if not more. That means robust, persistent demand for the goods and services that comprise modern lifestyles, from white-line appliances to travel and entertainment. India alone already boasts more than 500 million smartphone users, allowing them to shop online, conduct financial transactions, book air and train tickets, and take advantage of e-learning programs. Smartphone penetration is even greater in China, where deployment of next generation 5G wireless technology has already reached dozens of cities, far ahead U.S. and European implementation.
8. Less Dependent on Global Growth
Thanks to expanding middle classes with material purchasing power, emerging markets are far less dependent on manufacturing, commodities and export growth than they used to be. Consumption in China, for example, accounts for about 61% of GDP, while gross capital formation represents 20%, and net exports of goods and services also just 20%, down from more than one-third of GDP shortly before the Global Financial Crisis. Even in commodities-rich Brazil exports now amount to less than 15% of GDP, in considerable contrast to say, Germany, where exports-to-GDP stands at close to 50%. Greater domestic consumption means emerging markets have become less vulnerable to slowing global growth. In fact, emerging markets are leading global growth: Bloomberg composite forecasts put emerging market growth this year at 4.5%, three times the 1.5% for developed economies.
9. Better Equity Index Leadership
Healthy demographics, rising income and economic maturation are also reflected in the MSCI Emerging Markets Index, the composition of which has changed significantly over the last decade. At the end of 2009, energy and materials together accounted for about 30% of the index, while technology was just less than 15%. Today, energy and materials represent 14.7% of the index and technology, including tech-related consumer discretionary and communications services industries, comprises nearly 30%.
10. Lower Volatility
Because commodities tend to be more cyclical and sensitive to changes in U.S. benchmark rates, given that they are effectively priced in dollars, their lower weighting in the index tends to reduce the index’s volatility. And because tech is less rate sensitive, its greater index weighting also tends to damp index volatility. In the decade through 2009, MSCI EM Index standard deviation was 1.4x that the MSCI EAFE Index. Over the last decade, its standard deviation decreased to 1.2x of the MSCI EAFE Index. Emerging markets, in other words, have become a smoother ride for investors.
Attractive valuations, faster economic growth, expected stronger earnings growth in U.S. dollar terms, improving political risk and regulatory backdrops all bode well for emerging market equities in 2020.