- Emerging markets saw a positive first quarter overall, although pandemic challenges remain an overhang on the global economy.
- We think EMs will likely stay resilient in the face of new challenges.
- We expect a sharp earnings rebound in EMs this year from a low base last year.
- EM equities rose over the first quarter, but lagged developed market stocks.
Emerging markets saw a positive first quarter overall, although pandemic challenges remain an overhang on the global economy. Our emerging markets equity team thinks emerging markets are likely to remain resilient, highlighting the global competitiveness of emerging market companies and the ability of banking systems to withstand stresses.
Three Things We’re Thinking About Today
- Chinese internet stocks have struggled in recent weeks amid tighter regulatory scrutiny, higher US Treasury yields and block trades linked to a troubled hedge fund. China’s increased emphasis on fair competition, consumer protection and data security within the internet industry has been a chief concern. Though regulatory news could drive near-term share-price volatility, we remain largely confident in the longer-term fundamentals of several leading internet companies. These companies have grown rapidly by offering superior user experiences and efficiencies, and we expect these strengths to continue underpinning their structural earnings power. We also think that regulators are keen to ensure the sustainable development of the internet space for all stakeholders, rather than curb its growth. We are mindful of the dispersion in valuations across the internet space, and we seek to invest in quality companies trading below what we consider to be their intrinsic worth.
- Brazil’s fiscal challenges have returned to the spotlight as an intensifying pandemic adds pressure on the government to ramp up already massive spending. Concerns about the country’s mounting debt burden have weighed on its stock market and currency. Complicating matters, rising domestic inflation has narrowed the scope for monetary policy support. The central bank raised its key interest rate from a record low in March, signaling the start of a rate-hike cycle. We believe that Brazil’s economic recovery will rely heavily on the government’s ability to implement long-awaited structural reforms. Meanwhile, as a major commodity exporter, Brazil is likely to benefit from rising prices for commodities, as well as their broad appeal as an inflation hedge. We expect higher interest rates in Brazil to bode well for banks, especially market leaders that have weathered the pandemic with the help of strong capital positions and large deposit franchises.
- The global competitiveness of emerging market (EM) companies has been a standout feature amid market swings and pandemic worries. A widespread chip shortage has underscored the world’s reliance on Taiwanese and South Korean semiconductor firms, which have dominated the global industry with their strong manufacturing capabilities. South Korean battery makers have become key suppliers of electric vehicle (EV) batteries, supporting EVs’ growing penetration on the back of favorable policies and advancing technology. Chinese biotechnology companies working on innovative treatments for cancer and other major diseases have reaped growing success in licensing their new drugs to global pharmaceutical firms. Across industries, we have found increasing evidence of EM companies scaling the value chain, and we see durable growth characteristics in many of them.
Fresh waves of COVID-19 infection have continued to test economies and health care systems globally, just as more countries step up the rollout of vaccines. We think EMs will likely stay resilient in the face of new challenges. Many EMs have remained less leveraged than developed economies at the sovereign, corporate and household levels. EM banking systems have largely withstood stress despite loan moratoriums. Technology and consumption have also become new drivers of economic growth for many EMs.
We expect a sharp earnings rebound in EMs this year from a low base last year. According to our analysis, EM earnings have been the top driver of total returns in the MSCI Emerging Markets Index historically (see accompanying chart). Notably, digital transformation and innovation - which accelerated during COVID-19 - have translated into higher free cash flow generation. This cash flow has helped deleverage balance sheets. It has also found its way back to investors through dividends and share buybacks, and encouraged companies to adopt improved governance standards and better capital discipline. In our view, these all add up to a higher quality earnings story in EMs.
Reflationary expectations and higher US bond yields have stoked market volatility. Though inflation has picked up from low levels last year amid recovering economic activity, firmer commodity prices and near-term supply chain bottlenecks, we believe considerable slack remains in many economies, especially on the labor front. Also visible to us are longer-term deflationary risks arising from technology advancements and demographic headwinds. Rather than position for specific macroeconomic scenarios, we strive to build well-diversified portfolios that can potentially navigate a range of market environments.
A long-term, stock-driven, and valuation-aware focus is central to our investment approach. We seek companies with sustainable earnings power, trading at discounts to our perception of their intrinsic worth. We have found many such companies operating in areas of secular growth related to technology and consumption. Of particular appeal to us are business models and management teams that display agility and resilience in a fast-changing world.
Emerging Markets Key Trends and Developments
EM equities rose over the first quarter but lagged developed market stocks. Gains in the early part of the quarter cushioned EMs from losses in the final weeks, as optimism around increased US stimulus, COVID-19 vaccination drives and improved economic prospects waned amid concerns over rising inflation, higher US Treasury yields and resurgent outbreaks. EM currencies broadly weakened against the US dollar. The MSCI Emerging Markets Index rose 2.3% over the quarter, while the MSCI World Index returned 5.0%, both in US dollars.1
The Most Important Moves in Emerging Markets in the First Quarter of 2021
Emerging Asian equities finished the quarter higher despite weakness in March. Taiwan’s technology-heavy index rallied over the three-month period as the economy benefited from strong technology exports. Indian equities climbed. An expansionary fiscal budget, an inoculation campaign and stronger economic activity helped investors look past rising COVID-19 cases in the country. Conversely, China’s market fell after shedding early gains. Caution around monetary policy, stock valuations, US-China tensions and increased regulatory scrutiny of Chinese internet firms overshadowed a continued economic recovery. Stocks in the Philippines slid as a widening contagion led to renewed restrictions in the country’s capital.
Latin American equities fell over a volatile quarter. Brazilian stocks retreated amid a jump in COVID-19 cases, growing fiscal concerns, signs of increased state interference in the economy and heightened political noise ahead of next year’s presidential election. The Brazilian real weakened. In Peru, equities declined as a new wave of outbreaks added to uncertainty around the country’s presidential election in April - polls suggested no clear favorite to win the race. In contrast, Mexican equities gained. Mexico’s central bank raised its economic growth forecast for the year, thanks in part to a stronger outlook for US industrial activity.
Markets across Europe, the Middle East and Africa recorded a strong quarter as a whole. An upswing in oil prices buoyed Russian equities, although worries of potential US sanctions against Russia checked returns. Higher oil prices also provided a positive backdrop for Saudi Arabia’s market. South African stocks rallied on firmer commodity prices, the country’s vaccination drive, and a reopening economy. However, Turkish equities tumbled, as did the lira. Turkey’s president dismissed the central bank’s governor shortly after it announced a sharp interest-rate hike to tame inflation, igniting fears of a premature return to looser monetary policy in the country.
The graphic reflects the views of Franklin Templeton Emerging Markets Equity regarding each region and are updated on a quarterly basis. All viewpoints reflect solely the views and opinions of Franklin Templeton Emerging Markets Equity. Not representative of an actual account or portfolio.
Green = positive, Red = negative, Blue = neutral
What Are the Risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with foreign investing, including currency fluctuations, economic instability and political developments; investments in emerging markets involve heightened risks related to the same factors. To the extent a strategy focuses on particular countries, regions, industries, sectors or types of investment from time to time, it may be subject to greater risks of adverse developments in such areas of focus than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. Smaller and newer companies can be particularly sensitive to changing economic conditions. Their growth prospects are less certain than those of larger, more established companies, and they can be volatile.
1. Source: MSCI. The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging-market countries. The MSCI World Index captures large- and mid-cap performance across 23 developed markets. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or guarantee of future results. MSCI makes no warranties and shall have no liability with respect to any MSCI data reproduced herein. No further redistribution or use is permitted. This report is not prepared or endorsed by MSCI. Important data provider notices and terms available at www.franklintempletondatasources.com.
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