Did you know?

• 9 in 10 of “Generation Z” (4-24-year olds) live in emerging or frontier markets, 20% live in India¹
  
  
• 58% of the USD 3.4 trillion global e-commerce space is concentrated in just six companies, four of which are Chinese²
  
  
• The largest Indian retail brokerage Zerodha had more daily trades than Robinhood in 2020³
  
  
• China’s best-selling electric vehicle is currently a car called the Wuling Hong Guang Mini EV which costs about USD 4,200 compared to USD 42,691 for the Tesla Model 3⁴
  
  
• Solar (photovoltaic) and onshore wind are now the cheapest sources of new-build power generation for at least two-thirds of the global population, before subsidies⁵
  
  
• 128 countries have pledged carbon neutrality by 2060, covering 56% of total emissions⁶. This will increase to 71% when the USA makes this pledge, which we expect in 2021
  
  
• Global companies report almost USD 1 trillion of value at risk from the physical and transition effects of climate change, whilst CDP estimates the value of climate business opportunities at USD 2 trillion⁷
  
  
• Emerging market economies represent 41% of global GDP, though only 20% of the global market capitalisation⁸
  
  
• 43 out of the world’s 50 fastest growing economies from 2020-2025 are expected to be frontier markets with an average annual GDP growth of 6.9%⁹

These are just some of the themes we think about when selecting companies to invest in.

 

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Executive summary

After an exhilarating 2020, we believe it is shaping up to be a very strong 2021 for global equity markets, with emerging and frontier markets highly likely to outperform. There are six reasons for this:

1. Highest global economic growth for 44 years (up to 6% GDP) as vaccines bring mobility and consumption roaring back

2. Ultra-low interest rates in developed markets and a new normal of lower rates for emerging markets that will push investors into equities, boost valuations and drive the continued flow of retail investors into markets

3. Biden in the White House, whose appointment removes a significant number of tail risks meaning a lower equity risk premium globally, especially in emerging markets

4. Massive monetary and fiscal stimulus, with central banks’ balance sheets expanding by 29% of GDP in 2020-2022 versus 7% of GDP during the Global Financial Crisis

5. Softening USD as US real rates move further into negative territory due to the FED’s average inflation targeting and net FDI flows into the US turn from positive to negative

6. Superior earnings growth (2021 EPS growth of 33% in emerging markets compared to 20% for S&P 500) but 32% discount to S&P 500 on P/E multiples

 

1. Highest global economic growth for 44 years

After a 3.9% fall in 2020, global GDP will increase by up to 6% in 2021. This will be the highest global GDP growth since 1976. Driven by strong rebounds in China and India, emerging markets will fare considerably better than developed markets, losing 2.6% of GDP in 2020 and rebounding over 6% in 2021. Developed markets will drop 5.5% in 2020, before rebounding some 4.5%-5% in 2021.

The reason for this strong growth is simple. While 2020 saw the deepest recession since World War II, it was also the shortest. Unprecedented fiscal and monetary support from governments across the world meant relatively little scarring from the lockdowns, with the pent-up demand meaning that as soon as vaccines allow for a resumption to normal life we will see a strong economic impulse, supported by low base effect. We note it is not just physical restrictions (i.e. lockdown rules) that are curbing spending but the psychological impact of the virus. Just the knowledge that the vaccine is rolling out in Q1-Q2 should be enough to boost consumer spending, particularly in the tourism and hospitality sectors.

On the vaccine front, we would like to highlight that there are currently 13 vaccines in Phase 3 trials, including three in China, one in Russia and one in India. Hence, while we are likely to get setbacks in individual vaccines, the sheer number of promising candidates means that we expect the vaccines will get to the people that need them within 2021. Russia for example plans to produce 1 billion doses in 2021 (enough for 500 million people) and charge a reasonable USD 10 per dose. China could produce 1.5 billion doses next year.

 

2. Ultra-low interest rates

Currently over 25% of all bonds are trading at negative yield (some USD 16.5trn), with only 10% of global fixed income instruments trading at a yield above 2%¹⁰. The US ten-year yield is 84 bps, despite the fact that the latest inflation print (October) was 1.2% in US.

Furthermore, in the US the spread of the S&P 500 dividend yield over the ten-year US government bond yield is at its highest since the 1950s. Hence it is very hard to see an attractive case for bonds given the almost guaranteed negative real return and highly asymmetric risks as interest rates and yields are likely to start rising at some point. Hence the “TINA” philosophy (There Is No Alternative) remains very much relevant – it is difficult to see why investors would choose fixed income if they have the option to invest in equity.

It is also important to highlight that this new low rate environment is not just a developed market phenomenon, and in most of our key markets we have seen a very steep fall in interest rates, with notable exception being China, where the ten-year bond yield is currently 3.4%, the highest level since last April. Nowadays 2-4% is the “new normal” for policy rates, whereas in 2016 we were used to double digit key rates, as shown in Figure 1. This has very significant implications for valuations, especially for growth companies whose value is primarily in the later years.

 

Figure 1. Key policy rates in selected emerging markets

Source: Bloomberg, accessed 27.11.20

The final impact of low rates is that it has helped drive a boom in retail investing worldwide. Robinhood in US is the most widely known, though this phenomenon is global and has provided a key support for markets from India to Poland. Dividend yield currently exceeds the one-year deposit rate in two thirds of emerging markets, often by quite a few percentage points – for example one-year retail deposit rate is around 3.8% in Russia, whereas the dividend yield is 6.2%, as a result of 350bps of rate cuts in the last two years. This trend has been accelerated by the rise of much more intuitive online brokerage apps with better user interfaces that makes investing more appealing and accessible.

 

3. Joe Biden in the White House

The fact that Joe Biden has not only won the US election but appears to be ascending to power without too many hitches is very positive for financial markets, as it removes many tail risks. The most obvious direct impact is lower equity risk premiums, as he and the team he has assembled look to be much more of a “safe pair of hands” than the previous administration. While he is not going to be soft on China, we expect that his policy will be much more predictable and hence less disruptive for global markets. Additionally, most of his first year in office will be occupied by domestic issues (covid / stimulus) and (hopefully) climate change. Hence there should not be appetite and capacity to launch an aggressive Trump-style trade war.

On the domestic side, we expect that a Biden administration is likely to add additional fiscal stimulus in 2021 of USD 1-2 trillion, which will be supportive for global demand. The fact that the Democrats are unlikely to get a firm majority in the Senate is positive in that it reduces the risks of substantial tax rises (i.e. a reversal of the Trump corporate tax cuts) and of damaging regulation for the tech sector. This reduces the tail risk of a significant sell off in the S&P 500, which would in turn be damaging for emerging and frontier markets.

 

4. Massive fiscal and monetary stimulus

During the Global Financial Crisis (2008-2010), G4 (US, ECB, Japan, UK) central bank balance sheets grew by USD 2 trillion (7% of GDP), though from 2020-2022 we will have seen USD 13 trillion of asset purchases, a staggering 29% of GDP, as illustrated in Figure 2. Such aggressive monetary policy has played a crucial role in shielding asset prices and the financial sector from the impact of the coronavirus.

 

Figure 2. G4 balance sheet in USD trillion

Source: Bloomberg, Morgan Stanley, accessed 30.11.20

Looking longer term, from 2008-2019, G4 central bank balance sheets expanded by some USD 10 trillion. The impact of this can be seen very clearly in Figure 3, where we have also added some thoughts on the next ten years. Despite a real economy growth of up to 46% from 2008 to June 2020 (US nominal GDP growth), financial asset prices have grown by 100% to 370%.

In 2020-2022 asset purchases will be more than we have seen in the last 11 years in total, and hence we think markets will remain very well supported with liquidity. It is worth noting, however, that it is hard
to see how bonds could get any more expensive after such a rally in the last ten years (especially given the asymmetric risks we discuss above), hence money will flow into equities. Another relevant question is whether S&P 500 could return another 370% – looking at valuations, this does not appear to be the case. Emerging markets, therefore, would logically be one of the winners.

 

Figure 3. Total return from January 2009 – November 2020, in local currency

 

Source: Goldman Sachs, East Capital

 

 

2020 also saw unprecedented levels of fiscal stimulus, with global fiscal deficits reaching 12.7% of GDP¹¹. This provided income support and kept consumers going despite the historic drop in GDP and higher unemployment across the globe. Fiscal stimulus will fall from 2020 levels, with global deficits improving to 7.6% of GDP. However, the lag in impulse means that still up to one third of the impact from the 2020 stimulus programs will be felt in 2021, and of course we do expect more support, especially in the US. This is another positive for economic growth and equity markets in general.

 

5. Softening USD

We think the USD will carry on softening as we have seen since April 2020 (Figure 4), particularly against emerging market currencies. There is little doubt this would be positive if true – in the last 15 years there is an 82% hit rate of emerging market outperformance compared to developed markets during periods of USD weakness, and 100% hit rate for positive return.

The main logic behind this expectation is that (1) the relatively high nominal interest rates in the US (compared to other developed markets) have now disappeared and (2) the very significant decision of the FED to move to average inflation targeting means they will let inflation run well above 2% (perhaps up to 3%) before raising rates. This has the perverse effect of ensuring that real rates may become more negative throughout 2021 as inflation rises. As a result, the USD just does not seem like a particularly good store of value, especially in a more “risk-on” environment.

We also expect that 2021 will mark a turn-around in the significant net FDI flows into the US, which took place especially in 2018–2019 on the back of Trump’s protectionist policies and tax breaks on repatriation of cash abroad. Net FDI flows were USD 400bn in 2018 for example. This will significantly reduce demand for the USD and contribute to a softening of the currency.

More simply, however, many currencies we look at just look either oversold (rouble, lira) or set to outperform on clear economic growth outperformance (renminbi), and it is notable that on a trade weighted basis, the USD has strengthened by 24% versus emerging market currencies since 2006.

We also like to remind ourselves why USD weakness is so positive for emerging and frontier markets:

 

1	Translation effect	Local currency earnings grow more in USD, i.e. higher earnings growth for foreign investors
2	Inflation effect	Inflation falls or remains low due to cheaper imports (hence lower for longer rates)
3	Lower interest rates	Portfolio flows lead to lower interest rates, which means lowest debt service costs and ability to lever up
4	Stronger commodity prices	Beneficial for certain emerging market countries (more details below)
5	Valuation effect	A 5-6% local yield (both dividend and bonds) in certain countries looks a lot better if you believe that you will get uplift from currency strengthening
6	Virtuous circle	All the above factors act to reinforce each other to create a positive feedback loop, which leads to further currency strengthening

 

Figure 4. Return of USD vs trade weighted currency basket since 2006

Source: Federal Reserve Bank of St Louis, accessed 27.11.20

 

6. Significantly higher earnings growth but large discount

In 2021, earnings growth in emerging markets is expected to be considerably higher than in the US (33% vs 20%), as per Figure 5. Despite this, S&P 500 is trading at 21.3x P/E for 2021 (before Tesla is added to the index!) vs emerging markets trading at 14.4x P/E, i.e. emerging markets have a 32% discount.

While it is true that S&P has a high tech+ weighting, which are sectors we believe rightly deserve higher valuations, many investors do not realise that the global emerging markets index has only 1% lower tech weight at 40% versus 41% – see Figure 6. This chart also highlights that if you do believe in the long-term outperformance of tech names going forward, emerging markets should be one of your two bets alongside the US, while Japan and Europe are a very long way behind.

 

Figure 5. EPS growth in emerging markets and the US

Source: Yardeni Research, data as of 12.11.20

 

Figure 6. Tech+ market share by region

Source: Credit Suisse, as of 30.11.20

This emerging market valuation discount has been driven by ten years of zero net flows into emerging markets as an equity class. As a result, the market capitalisation of emerging markets as a percent of global market cap has remained broadly stable (even fallen) over the last 10 years, despite a notable rise in GDP as a percent of global GDP (34% to 41% now). This is illustrated in Figure 7. We expect that both of these metrics will increase going forward, with the former increasing partly due to increased capital markets activity in emerging markets.

Another way to look at this is that the proportion of emerging market funds as a percent of overall global equity under ownership has fallen from above 13% in 2010 to just over 7% now.

This low allocation gives us confidence that even if it is not a very strong year in developed markets equities (which can be argued considering the FAANG valuations), we could see a rotation in to emerging markets, and hence still positive returns and outperformance.

 

Figure 7. Emerging market share in global GDP and of total market
capitalisation

Source: IMF World Economic Outlook October 2020, Bloomberg, accessed 02.12.20. Emerging market capitalisation has been calculated by using the market capitalisaion of the MSCI Emerging Market Index plus the market capitalisation of the China-A shares index before it was added to MSCI Indicies; the Saudi Aramco market cap was excluded due to its large size (USD 1.8 trillion) and very low true free float.

 

Special topic – tech and disruption

One of the impacts we (and the rest of the market) have been focusing on is that coronavirus and the associated lockdowns have catalysed three years of change in three months and we saw a permanent structural shift towards online in all aspects of life. In fact, we are now reaching levels of e-commerce penetration that were previously expected in 2024¹². This disruption will continue, and there will be more companies for whom long term growth prospects will improve thanks to digitalisation, including the ones from more traditional industries which have been the quickest to adapt. We believe it is these latter names which look particularly attractive given (much) more reasonable valuations, and we put a lot of effort into researching and analysing the tech part of non-tech businesses.

As for the more traditional tech names, while many do look slightly expensive if you look at one-year earnings multiples, we typically take more of a “sum-of-the-parts” approach. For example, names like Alibaba or Yandex are generally analysed for their core businesses (e-commerce and search respectively), but both companies have fast growing cloud businesses and a strong pipeline of innovative new lines of business. For example, Yandex is one of the top three companies globally in terms of self-driving car miles. These are examples of business lines that we are sure the market is not pricing in or paying enough attention to – there are many more.

More generally, we note that the incredibly fast pace the world is changing, with disruptive tech everywhere redefining how we work and live our lives. In five years, you will probably be driving an electric car (if you aren’t already), do most of your healthcare and all of your food shopping online and consuming most of your media though virtual reality. As long-term investors our job is to identify the true winners of these trends – there will be many that will fall by the wayside.

 

Special topic – sustainability

2020 was a tipping point for sustainability, with governments, corporates and investors around the world finally starting to “put their money where their mouth is”.

From an asset manager perspective, despite the coronavirus, ESG funds received USD 120bn of net inflows globally up till the end of October¹³, a stark contrast to broad equity funds which experienced net outflows of over USD 125bn. We expect these flows to continue, and to some extent this will make the ESG theme a self-fulfilling prophecy – companies with either strong or improving ESG profiles will continue to outperform partly because lots of investors are buying them.

From a governmental perspective we saw a raft of “net zero” announcements, with perhaps the most notable being from China’s net zero target by 2060, which will reduce expected global warming by a very significant 0.2-0.3°C¹⁴. This would require some USD 26 trillion of investment¹⁵, generating considerable opportunities for well-placed companies. Due to these announcements and the expected US climate pledge, we believe the renewables sector globally (and associated industries) offers one of the best long-term structural growth stories around. By digging a bit deeper, it is possible to find relatively cheap plays on this theme, such as a Chinese wind turbine producer trading at 12.8x 2021 P/E with 38% earnings growth.

Going forward, with ten years left on the journey to “Agenda 2030”, we expect that the focus on the Sustainable Development Goals will intensify even further. Climate action (Goal 13) will likely remain at the top of all investors’ agendas as the key risks become increasingly tangible and visible. These are transition risks (increasing carbon prices or carbon border taxes in many countries) and physical risks (an accelerating number of extreme weather events).

Our proprietary model to assess transition risks (more here) has proved useful in highlighting the materiality of an increasing global carbon price not just for ourselves but for the companies we engage with. For example, the implied valuation of steel companies in Russia could fall by some 50% in our base case if the EU was to impose carbon import duties on the border from 2022 – this is a powerful message to show to executives and board members, which we do.

We know many of our portfolio companies are now doing similar analysis, and partly due to this we expect that 2021 will be the year where we finally get a significant number of emerging market companies publishing Paris-aligned long-term strategies. Given that many of these companies are very large emitters, the “real world” impact on emissions (and hence global warming) would be significant. This would vindicate our long held belief that in order to really make an impact on the world, engagement rather than divestment should always be the preferred method, and that “greening the brown” is a very important (but often overlooked) piece of the puzzle in meeting the Paris goals. This is especially true in countries like Russia where the government’s climate change policy is not sufficiently ambitious.

We also note an increased focus on biodiversity and natural capital, as investors, companies and governments wake up to the financial materiality of the damage we are doing to our ecosystems. The numbers are quite scary – the World Economic Forum recently estimated that more than half the world’s GDP (USD 44 trillion of economic value generation) is moderately or highly dependent on nature¹⁶. Similar to climate change, we believe that the large publicly-listed companies have a crucial role to play here, as they are often ahead of governments. We will accelerate our engagement efforts on this theme, though are already in dialogues with the most exposed names in our portfolio, such as a F&B company in India and two Brazilian banks. We also expect (and hope) that a global reporting framework on biodiversity will follow, perhaps the TBFD, in line with the TCFD.

Finally, we have been pleased to observe a significant uptick in companies implementing TCFD and SASB¹⁷. This year we urged all our portfolio companies to implement these standards (see our CIO’s letter here) as we believe they help companies (and investors) identify the ESG metrics most material for their sector (SASB) and provide an excellent framework for integrating climate change into long-term strategies (TCFD). Going forward, the recent announcement that all the standards organisations will start working together will hopefully make it even simpler for corporate issuers to identify and disclose material topics.

 

Special topic – commodity outlook

We won’t focus too much on commodities, though suffice to say – we are generally constructive, although note that different commodities have different drivers.

Oil looks set for further rebound on structural deficits on the supply side and a further pick-up in demand as the vaccine increases mobility levels further. Indeed, the consensus USD 50/bbl average for 2021 looks very conservative given that we are already at almost USD 49/bbl. Gas prices are already above January levels, hence we see less upside. Obviously, rising oil prices are not good for oil importers, though this will provide a positive stimulus for countries like Russia and Brazil, which have underperformed so drastically this year (returning -11% and -28% compared to +11% for the emerging markets index, all in USD).

One area where we have spent a lot of time researching this year is base metals with exposure to the renewables theme, particularly in Eastern Europe where we invest in some of the world’s largest nickel, copper and silver producers. We have long argued that liking Tesla but not liking the provider of the main ingredient of their battery (1/3 of the cost of a Tesla battery is nickel) is somewhat duplicitous, especially when the latter trades at a 16%-18% dividend yield for 2021. Copper in particular looks appealing, and renewable power installations can have up to six times more copper content per MWh than fossil fuels and electric cars can have twice as much copper as their polluting peers. When you combine this with a property boom in China (property investment is up 6.3% YoY YTD),
it is quite easy to be positive here.

Steel prices have staged a surprisingly strong recovery, with Black Sea HRC prices the highest since 2011, up 31% this year. We don’t see too much room for upside from this level, though we think that this does to some extent show the strength of the economic recovery, which is likely stronger than you would think if you are living in Europe and seeing closed restaurants and empty shops. This is supported by global composite PMI levels, which have remained above 50 since July, and are currently 53.

 

What could go wrong?

While this is our most bullish outlook in many years, our view is not wildly different to consensus. For this reason, an unusually large part of our conversations leading up to this outlook has been on what could go wrong. Of course, there are risks and we have learnt the hard way in emerging markets to expect the unexpected, though we highlight below two broad areas we are focusing on.

1. Disorderly inflation. With such a strong economic recovery and ultra-low rates, it is logical to expect some sort of inflation. However, inflation per se is not bad, and from 1929 to 2019, equities markets have delivered their highest annualised return when inflation has been below 1% but rising¹⁸, which is the situation we will be in next year.
   
   However, if we were to see a more material pick-up in inflation, rates would go up with negative implications for equity markets, especially emerging markets.
   
   The FED’s shift to average inflation targeting means they are going to tolerate a much higher level of inflation (perhaps up to 3%), and as such, we do see this as more of a 2022 problem, although markets are forward looking so even signs that this will be the case might spook investors.
   
   
2. 2022. While there is overwhelming consensus that 2021 will be a strong year, there is much less clarity about what 2022 will look like. On top of the inflation threat mentioned above, debt levels (both sovereign and corporate) will be at record levels. Sovereign emerging market debt will rise to 65% of GDP in 2021 (from 53% in 2019), with developed market debt at 125% of GDP, higher even than at the end of World War II¹⁹. This comes at a time that central banks are tapering down their asset purchases, government guarantee and labour support schemes have largely wound down and interest rates will potentially be rising.
   
   Particularly in emerging market economies, who cannot print money to the same extent as developed markets, the risk of “fiscal fatigue” remains acute, i.e certain countries will just not be able to raise any more debt and will have to pursue much tighter fiscal policies, with a corresponding damage to their economies.
   
   Questions over fiscal sustainability could lead to further pressure on rates in these weaker countries, which together with increased uncertainty regarding inflation and relatively high valuations, could lead to a strong risk-off mood in the markets and a stronger USD.

Among other risks, geopolitics is always an issue (China-India, China-US, Turkey, Russia?), particularly if the US pursues a more aggressive human-rights based foreign policy than the market is expecting.

 

Conclusion

We believe that 2021 will be a very strong year for global equity markets, with emerging and frontier markets outperforming. There are several relatively intuitive reasons behind this thesis, most notably a roaring economy, weakening USD and lower valuations in emerging markets. While there are risks, we believe that they will materialise closer to 2022 (if at all).

Bank of America recently polled 200 global asset managers (USD 520bn AUM), and the number 1 favoured trade is long emerging markets, primarily in equities. This trade has certainly started, with emerging markets return in the last two months almost twice that of developed markets (12.1% vs 6.4%, both in USD). However, we believe there is plenty to go.

 

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¹ Bank of America Merrill Lynch, 20.11.20
² Based on 2019 figure, “Outlook 2021”, Activate Consulting, October 2020.
³ “Fomo feeling’ propels Indian investors into stock market”, FT, 27.09.20
⁴ “Wuling Mini EV Shines In Hot Chinese Market”, Clean Technica, 25.11.20
⁵ Solar and Wind Cheapest Sources of Power in Most of the World”, Bloomberg, 28.04.20
⁶ “China going carbon neutral before 2060 would lower warming projections by around 0.2 to 0.3 degrees”, Climate Action Tracker, 23.09.20, East Capital
⁷ World’s biggest companies face USD 1 trillion in climate change risks, CDP, 04.06.19
⁸ IMF World Economic Outlook, October 2020, using IMF definition “"Emerging Market and Middle-Income Economies", Bloomberg, East Capital
⁹ IMF World Economic Outlook, October 2020
¹⁰ “Financial Stability Review”, November 2020, ECB
¹¹ IMF Fiscal Monitor, October 2020
¹² “Outlook 2021”, Activate Consulting, October 2020
¹³ Goldman Sachs, 06.11.20
¹⁴ “China going carbon neutral before 2060 would lower warming projections by around 0.2 to 0.3 degrees”, Climate Action Tracker, 23.09.20, East Capital
¹⁵ “Big investment needed to meet carbon goals”, China Daily, 14.10.20
¹⁶ “Nature Risk Rising: Why the Crisis Engulfing Nature Matters for Business and the Economy”. World Economic Forum, January 2020
¹⁷ Task Force on Climate-related Financial Disclosures and Sustainable Accounting Standards Board respectively
¹⁸ Based on S&P; GS
¹⁹ IMF Fiscal Monitor, October 2020