Portfolio manager breaks down the fundamentals enabling developing countries to leapfrog their more advanced counterparts
The COVID-19 crisis has been a monumental challenge for countries and their healthcare systems, and while vaccines are being rolled out, the emergence of new virus variants has scrambled an already unclear timeline of wide-scale immunization against the disease.
That’s weakened the outlook for economies worldwide, but a look at the fundamentals suggests that emerging markets may exhibit continued strength even as the pandemic wears on.
In a newly published note, Andrew Ness, portfolio manager at Franklin Templeton Emerging Markets Equity, said that many markets could experience muted growth this year, but more normalization is anticipated in 2022.
“Stress in emerging market banking systems has been manageable, despite the loan moratoriums and government support policies for borrowers in many emerging market countries.,” Ness said.
A major piece of the bullish emerging markets narrative comes from higher-quality earnings, which he argued has been spurred by the COVID-19 pandemic. It fast-tracked technological transformation and innovation in those economies, leading to higher free cash-flow generation relative to developed markets. That’s contributed to a deleveraging of balance sheets, dividends and share buybacks, and greater motivation for heightened governance standards and capital discipline among companies.
Citing data from Bloomberg, he said that annualized total returns for the MSCI Emerging Markets Index have topped those in the UK FTSE, S&P 500, and TOPIX benchmarks over the past 20 years. An internal analysis also pointed to emerging market earnings as the top driver of total returns in the MSCI EM Index over a five-year period.
And while emerging market equities appear undervalued relative to U.S. stocks with a price-to-earnings discount of -36% – a two-decade low – Ness noted that U.S. earnings multiples are sitting at a two-decade high. The real narrative of better cash flows, stronger balance sheets, improved capital efficiency, and less cyclicality among emerging markets should eventually manifest itself into a 2021 earnings rebound from a low 2020 base, he argued.
“Many of the themes we’ve been investing in for some time will likely remain relevant in a post-COVID-19 world, and some will even accelerate as a result of the pandemic,” Ness said. At the beginning of the pandemic crisis, many EM businesses had stronger balance sheets than their counterparts in developed markets, including some who were criticized for having high cash balances that now appear somewhat prudent in hindsight.
Countries that benefitted from institutional reforms in recent years also entered the crisis from a position of strength. With stronger foundations and greater fiscal flexibility compared to the past as well as to their developed-market peers, Ness said EM nations are poised for a smooth recovery from the pandemic.
Ness also highlighted how EMs like China are outgrowing their old dependence on Western countries, particularly as years of fiscal policy improvements set the scene for domestic consumption and technological advancements. Many EMs have overtaken the developed world in areas such as social media, messaging platforms, e-payment systems, online education, and healthcare, among many others.
“We think the longer-term story within emerging markets is positive, and look forward to uncovering investment opportunities in the years to come,” Ness said.
