EEM: Going Against The Grain By Investing In Emerging Markets

Summary

• Emerging market stocks are on a free-fall and the demand for safe-haven asset classes has risen exponentially in the last couple of weeks.
• COVID-19 is threatening the growth of the global economy but the impact will only last a few months at best.
• Leading financial institutions have revised their guidance for China's GDP growth in 2020 but still predict an above-5% growth.
• Being bold is difficult but often is the right thing to do when it comes to investing.

Source

It's easy to say that one has to make unpopular bets to earn alpha returns in equity markets. Putting this into action, however, can be a very challenging task because of our tendency to seek approval of other investors, which eventually results in following the crowd rather than making bold decisions. The subject of this analysis is not to identify and discuss a method as to how to overcome this barrier but to analyze one such unloved bet that could deliver stellar returns; emerging market equities. My preferred ETF to invest in this asset class is the iShares MSCI Emerging Markets ETF (NYSEARCA:EEM). Naturally, this needs careful evaluation as the fund is more geared toward Chinese equities, and the largest economic impact of the new COVID-19 virus will be felt by Chinese companies. After carefully assessing the prospects, the valuation multiples, and a few other macroeconomic developments, I find emerging markets to provide the best value for money.

This is not the first time I'm writing about emerging markets this year. On January 14, I published an article outlining why I believe EEM will deliver stellar returns in the year ahead. In particular, my analysis found that the demographic characteristics, the easing trade tensions, higher economic growth in comparison to developed countries, the supportive monetary policy decisions, and the cheap valuation will push emerging equity markets higher this year. What prompted me to evaluate the prospects once again is the outbreak of the new coronavirus.

An assessment of COVID-19's impact on emerging countries

It was China at first, but now it is South Korea and Italy. Soon, it could be many Asian countries, including India. Even though the World Health Organization has so far not classified the spread of the new virus as a global pandemic, it could soon do so considering the present status of the outbreak.

Let's look at the elephant in the room; China. A discussion of emerging markets that does not start with this East Asian nation has become rare for all the right reasons.

There are a few lessons to learn from the SARS outbreak, which is the most comparable situation to that of today. The first lesson, which is the most important one, is that there would be a drastic drop in the GDP growth of China in the next couple of quarters, but that is bound to be temporary. After contracting for two straight quarters during the SARS outbreak, the Chinese economy entered a massive growth phase.

Source: IHS Markit

IHS Markit further predicts that the overall economic impact of the new virus will lower the China GDP growth rate in 2020 by 0.2-0.8%. The Chinese officials, on the other hand, believe that growth could slow down as much as 1% this year. These are ominous signs for investors but the caveat is that the Chinese economy would still grow over 5% even after accounting for this drop, which, certainly, would be higher than many other regions of the world.

The more numbers we have, the better. The following table illustrates the revisions to the expected GDP growth of China by some of the largest financial services companies in the world.

Source: Pictet Asset Management

As we can see from the above table, all these institutions expect a significant blow to the Chinese economy in the first quarter of this year. However, this slowdown is expected to reverse in the second quarter, which is evident from the much smaller revision to the full-year guidance.

One thing to look out for is monetary and fiscal policy easing. In a meeting chaired by Xi Jinping on February 22, it was confirmed that authorities would look for all possible measures to revive the economic growth of the country once coronavirus fears subside.

Source: Bloomberg

PBOC's deputy governor Chen Yulu has already confirmed that the policymakers will conduct a financial inclusion review on commercial banks to offer qualified lenders discounts on their reserve ratios, which would result in the growth of money supply.

One of the primary arguments of naysayers is that rates are already low in China, which would make it difficult to provide a meaningful impact on growth by lowering this any further. However, investors need to assess alternative possibilities such as tax cuts and increased government spending as well, which are likely to make a larger positive impact in this low-interest-rate environment.

Chief China economist at Nomura International Lu Ting told Bloomberg on Saturday:

The current benchmark deposit rates are quite low anyway. Cutting the reserve requirement ratio, using lending facilities like pledged supplementary lending to fund loan extensions, tax cuts, rent cuts, and interest payments should be much more effective in the current situation.

As much as it's difficult to think of a recovery at this point in time, that is exactly what has happened during previous pandemics. Things escalated quickly and the outlook has suddenly become very challenging. China, the second-largest economy in the world, will likely report a strong recovery in the second half of 2020. That's the time to realize the gains and now is the time to tactically go overweight on China while the world is obsessed with safe-haven assets.

The situation outside China is very similar as well. One important consideration is how long can interest rates be lowered in these countries. Even though there are negative rates in some parts of Europe and historic lows in the U.S., the situation in emerging countries is a complete contrast. Most of these countries are growing at mid-single digits, which has enabled policymakers to keep rates high and steady. There's leeway for further rate cuts that could eventually reignite growth in many of these regions once China's economy stabilizes toward the latter half of this year.

Country	Interest rate
Pakistan	13.25%
Myanmar	10%
Maldives	7%
Sri Lanka	6.5%
Bangladesh	6%
Nepal	6%
India	5.15%
Mexico	7%
Brazil	4.25%

Click to enlarge

Source: Trading Economics

I expect most of these countries to be more accommodative this year than they initially planned for. The many advantages emerging markets possess over developed countries will come to the spotlight as markets return to their normal state. This is the catalyst that I'm looking for.

EEM as the preferred choice

EEM has a very high exposure to China, which has caused investors to look for alternative options to gain exposure to emerging markets. On the contrary, I believe it's best to do the opposite; bet on China that has a strong track record of delivering the goods. Even after a couple of recessions and the outbreak of SARS, the Chinese economy continued to grow at stellar rates over the last couple of decades. At this time, I see little to no reason why things would be different in the next few years as well. It's true that growth would not be as spectacular as it used to be, but the country will report a strong recovery with the help of the newly signed trade deal with the U.S., which is only the beginning from this front.

The asset allocation of EEM by region as of February 26

Source: BlackRock

EEM's exposure to India has increased gradually over the years, which is another positive. There have been only three confirmed coronavirus cases in India so far and those were students that came into the country from Wuhan, China. There would be supply problems for the country as India depends on China but once again, the difficult situation will only last a few months at best. The massive domestic consumer base should help many companies as well, which is in some way similar to the situation in the U.S., although at a much smaller scale.

Takeaway; be bold

Writing the above words were easier for me than to decide to buy more EEM shares. However, eventually, I did. With all the reports that I come across and the pessimistic view presented by Bloomberg TV anchors made it extra hard to do the right thing (as far as I see it), but not letting emotions get the better of an investor is something I advocate so I decided to act on it as well. The impact of the new coronavirus in the short term on emerging markets will be massive. However, the long term outlook has only changed a bit. The market reaction does not accurately reflect this. This anomaly has created a very attractive investment opportunity, and being bold can deliver eye-catching returns in the future. All the reasons that I discussed in my previous article are still valid and the COVID-19 virus is just a speedbump from a long term context.

Some investors have already joined the party. After two straight weeks of outflows, fund inflows were reported for emerging market funds in the last week.

Source: Financial Times

I believe it's time for others to join as well.

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Analyst’s Disclosure: I am/we are long EEM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.