A New Chapter for Emerging Markets
History, and our own experience, tell us that a key to investing success in emerging markets is getting the US Dollar trend right. In the two weeks since we published our latest EM Tour D’Horizon, we have had two notable events that solidify our view on the upward trajectory, though not yet the speed or exact timing, of local currency denominated emerging market assets. The events are of course the U.S. elections and the announcement by Pfizer of the latest results from their COVID-19 vaccine clinical trial, both of which mark critical milestones.
The U.S. election delivered a potential goldilocks scenario for emerging markets. First, a new president that promises a more scientific and methodical approach to vanquishing the pandemic (and governance in general) and a less protectionist view of the world, which should support global cooperation and trade. Second, a likely-to-be Republican Senate which will contain the new administration’s capacity to implement spending and taxation policies which could have produced a larger and faster stimulus package, greater deficit spending and, consequently, higher short-term US growth and interest rates.
We thus remain convinced that we are now past the inflection point in USD strength which we initially mentioned in our July Report on US Dollar Peaks (available here) and are in the early innings of a medium-to-long term cycle of EM currency strength. This conviction is based on a methodical analysis of previous US Dollar inflection points. Historically, sustained USD weakening cycles occur when policy makers deliver maximum fiscal impulse and expansionary monetary policy, and begin the quarter after a recession hits the US economy (in this case Q3). These structural cycles have lasted 5.8 years on average, with a multilateral US Dollar depreciation of more than 28%. We expect speed bumps along the way, including 1) a potentially messy transition of power in the U.S.; 2) a spike in COVID globally as winter arrives in the Northern Hemisphere; and 3) potential setbacks in the vaccine approval and distribution process. At this point however, we see these as short-term impediments in what increasingly seems an inexorable medium-term trend.
The clear first beneficiary of and purest play on a US Dollar weakening cycle is EM local currency debt. We project the asset class to generate 10-15% annualized USD returns over the next two years1, not only from strengthening EM FX, but also a meaningful yield averaging 4.2% for 5-year bonds. On top of that, regional and country differentiation constitute fertile ground for additional alpha gains. This asset class also enjoys the highest liquidity of any part of EM investing, as evidenced by our daily liquidity UCITs fund, described here.
EM equities of course also have an element of FX in their return stream, so should benefit from this trend as well. In addition, outside of Greater China, these markets experienced a disproportionate impact from COVID-19 due to 1) underrepresentation of new-economy and tech companies; 2) perception of higher economic risk due to a lack of institutional, especially healthcare, infrastructures and 3) disproportionate market impact during capital flight due to lower liquidity levels. This is despite the fact that in many such countries the impact of the pandemic was far lower than what has been feared due to young demographics and other factors. We believe the EM and frontier equity universe contains some of the deepest value (small emerging markets still trade at close to a 20% discount to their historical price to book ratios) and highest concentration of sectors that will benefit from activity normalization post pandemic. Thus, for this asset class the inevitable rotation from tech and new economy stocks to cyclicals and value investments, catalyzed by approval and distribution of a vaccine, should have an outsized impact on returns.
We have two TRG strategies which we think are well suited for this eventual value catch-up. The first takes a multi-manager approach with a focus on the larger emerging markets, discussed in detail here, which we think has the potential to generate 10-15% annualized USD returns over the next two years1. The second takes a concentrated, 25-35 stock approach to non-BRIC EM equities, which we project has the potential to generate 25-35% annualized USD returns over the same period1. Our latest letter, found here, elaborates on the current opportunity set.
We believe the stars are aligning for EM local market investing to embark on a positive, medium term trend of outperformance. Asset class, country and market timing differences will of course be important, but as we leave 2020 and head towards 2021, we think investors will be well served to put themselves on a path to adding to their exposures in these areas.
1. Projected returns allow the manager to differentiate amongst investments with varying risk and return characteristics. No assurances can be made that investment objectives will be achieved for any of TRG’s strategies, and the projected returns herein should not be viewed as an indicator of likely returns to investors. The projected returns do not reflect any fees and expenses, which are expected to be material and adversely affect returns. Projections are subject to great uncertainty. TRG cannot guarantee returns, and projected returns are included herein for informational purposes only. Please see the linked presentations for additional important information, including but not limit to, important information on projected returns.
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