Deglobalization and Emerging Market Opportunities
Author: Regina Chi
October 7, 2020
As the COVID-19 environment endures, uncertainty has crept back into the capital markets. In many countries, the first wave of the pandemic has been followed by a second and we just don’t know how long it will be until there is a credible vaccine. Meanwhile, the human toll has been grim. So has the economic one. Both could well get worse.
This ever-changing reality makes it difficult for investors to look beyond the pandemic to whatever the new normal will be when and if it recedes. Yet even in a macro environment that remains fundamentally unpredictable, there are still some secular trends that the pandemic has not disrupted. In our view, and specifically in the context of emerging markets (EM), one of the most important is deglobalization – the retrenchment of the global economy into a more protectionist, less interconnected and more heterogeneous construct. As economies regionalize and localize, independent country returns are becoming more uncorrelated with each other – and investors who still look at emerging markets as a single, unified asset class need to rethink their approach.
The pace of globalization has ebbed and flowed over the years. The most recent upswing, which can be roughly pegged to China’s accession to the World Trade Organization in 2001, was remarkable in its speed and degree, as technology dissemination and liberal trade policies conspired to create a period of hyper-globalization. Yet the tide now seems to have turned. Measures of trade openness – for instance, exports and imports as a percentage of GDP in a basket of representative countries – have been declining since 2017, according to UBS.
We believe this is occurring for three primary reasons. The most obvious is the increase in trade tensions and protectionist measures among many countries, including the United States, the world’s largest economy. The tech war between the U.S. and China have been grabbing headlines recently, but in fact, on a global basis, protectionist measures affecting trade in goods have been far outpacing liberalizing measures for the past decade, according to UBS. Another factor: technological shifts. In the era of smartphones and 3-D printing, the relative advantage of outsourcing manufacturing has declined; so, too, has the value of in-sourced technology to emerging markets. And finally, many emerging-market outsourcing destinations are maturing. Chief among them is China, whose labour and environmental cost advantages have declined rapidly throughout the past decade, while trade policy risk has increased.
This trend started long before COVID, but the COVID environment is likely to only accelerate it. The pandemic has disrupted global supply chains, which might well fall into permanent reorientation. It has also given political momentum to protectionist forces, as high-profile shortages of (foreign-made) medical supplies provide a focal point for trade policy worries. In this evolving world, China still looms large, but multinational corporations will be ever more likely to diversify their supply chains and adopt “China-plus” strategies to mitigate policy risk and lower costs.
The most important takeaway is that emerging markets can no longer be viewed as a homogeneous asset class. There are 26 countries in the MSCI Emerging Markets Index, and their differences from each other will increasingly become more important than their similarities as developing economies. Our data suggest that country-specific factors have accounted for about 30% of returns over the past decade. We expect that proportion to increase going forward.
For investors, the goal then becomes identifying outperformers on a country basis. How do we do that? One important step is to recognize the idiosyncrasies of many EMs. One is that GDP growth is generally very weakly correlated with stock market performance in emerging markets. According to Bloomberg, Brazil’s GDP growth barely beat 1% last year, but the Bovespa Index gained 27%; meanwhile, Indonesia’s economy grew by 5% in 2019, but its stock market returned only 10%, underperforming the MSCI Emerging Markets Index. This weak correlation reflects the fact that EM stock markets often only weakly mirror the composition of the country’s real economy.
Another idiosyncrasy about EMs: currency matters – a lot. EM currencies are generally more volatile than those of developed countries, in part because many rely heavily on foreign- (especially U.S.-) denominated debt. Those with stronger current accounts, and therefore relatively stronger currencies, are better insulated from developed economy monetary trends, and over the long term their stock markets tend to outperform other EM countries with weaker current accounts. That’s why one of the factors we pay very close attention to is current account-to-GDP.
One country that pops up in our analysis is Taiwan. While not immune to the uncertain global demand backdrop, the country is bolstered by a strong balance of payments and steady pace of economic and earnings recovery. In part, this is due to its strong COVID-19 response relative to the emerging markets universe, but with almost 28% of total exports to China, it also helps that
Taiwan has benefitted from its largest trading partner’s sharp V-shaped recovery.
We are not in any way calling the end of globalization: it is far too late to put that genie back into the bottle. As it has ebbed and flowed in the past, we think it has just receded given each country’s own national policies. In the meantime, a more regionalized and localized landscape is evolving. This evolution will increasingly challenge traditional approaches to emerging markets, but it will also present investors with new opportunities – if they know where and how to look for them.
Regina Chi is a Vice-President and Portfolio Manager at AGF Investments Inc. She is a regular contributor to AGF Perspectives.
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