GMO: 5 Reasons to Own Emerging Market Stocks Now

News July 13, 2020 at 11:28 AM
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The Ping An International Finance Center (Ping An IFC), centre left, and other buildings at dawn in Shenzhen are seen from the Ma Tso Lung district of Hong Kong, China, on Thursday, June 8, 2017. Shenzhen is pivoting from its legacy as ground zero for China's manufacturing boom into a center for research, development and production of advanced technology. Photographer: Justin Chin/Bloomberg The Ping An International Finance Center towers over Shenzhen, China. (Photo: Justin Chin/Bloomberg)

For years, emerging market equities have been favored by many strategists for their strong potential growth and relatively cheap prices compared to developed market equities, but they frequently disappoint.

Even last year when the MSCI Emerging Markets Index climbed 18.4%, the S&P 500 gained over 60% more, up 30%.

This year, however, could be different, according to the emerging markets team at Grantham, Mayo, Van Otterloo & Co., led by Amit Bhartia and including Mehak Dua and Alvaro Pascual. They cite the smaller drawdown from peak to trough during the current pandemic-fueled crisis compared to six previous sharp drawdowns between late 1997 and early 2018, including the financial crisis of 2008. The average decline for those drawdowns was 41%; in the first quarter of this year it was 33%.

Whether the bottom was reached in emerging and developed markets during the first quarter remains to be seen given the continuation of the COVID-19 pandemic, but many emerging markets, such as China, Taiwan and South Korea, have seen a sharp drop in coronavirus cases. Others, such as Brazil and India, have not.

In a new research paper, the GMO emerging markets team outlines five critical changes that make emerging markets "more resilient today" than they've been in the past, using the MSCI Emerging Markets Index as the benchmark.

1. The weight of vulnerable countries in the index has declined significantly.

In 2012, over 30% of the index consisted of nine vulnerable economies including Brazil, Turkey and South Africa. Today they account for less than 20% of the index.

2. China's weight in the index has increased substantially.

China now accounts for 40% of the MSCI emerging markets index and is less vulnerable than other emerging markets with the fiscal and monetary wherewithal to rebound from temporary economic setbacks. 

Its government has spent only 5% of its GDP on fiscal stimulus during the pandemic, less than half the 11.5% it spent during the 2008 financial crisis and 13% of GDP spent by the U.S. this year, leaving it room to spend more if necessary.

3. Cyclical sectors hold a smaller share in the index.

In 2010, cyclical sectors such as energy and materials accounted for 30% of the MSCI Emerging Markets Index. Today they represent about half that, while internet and technology stocks account for about one-third of the index, making the index less vulnerable to the ebb and flow of the economic cycle.

Moreover, even the more vulnerable sectors in the index, such as Russian and Brazilian energy and materials sectors, are stronger, having reduced their debt-to-equity ratios.

4. The quality of financial stocks in the index has improved significantly.

Financial stocks account for about 20% of the MSCI index and are the largest single sector weighting in the index, but their composition is less risky than they were previously, according to the GMO EM team. 

Chinese banks account for 36% of the financial sector weighting in the index, up from 25% 10 years ago, and are in much better shape today than they were in the past, according to the GMO team.

Banks in vulnerable economies with poor external balances and a reliance on foreign savings — South Africa, Chile, Colombia, Argentina, Egypt and Pakistan — account for just 10% of the financial sector weighting, down from 46% previously.

5. Many emerging markets are well-prepared to respond to the COVID-19 pandemic.

Only three EM countries were rated high risk by the GMO team, which rated each emerging market for risk and its ability to respond from the current pandemic-fueled crisis, and they have a cumulative weighting of 9% in the index. The three are Mexico, Brazil and Indonesia.

In contrast, four countries — China, Taiwan, Thailand and Korea — with a cumulative 66% weighting were rated "safe" and are expected to perform better as they recover from the crisis and their economies reopen.

Conclusion

The GMO report concludes that the MSCI emerging markets equity index is "healthier" today than in the past, though not without potential risks.

Those possible risks include a reemergence of the U.S.-China trade war, power struggles and rising nationalism in some large EM economies, such as India and Brazil, continuing tensions between China and Hong Kong, poor health care infrastructure in many EM countries, currency risks, and a heavy concentration of just a few stocks. Five stocks of the MSCI EM index represent 22.5% of the index, but that is not so different from the S&P 500, where five stocks account for 20%. 

The top five stocks in the MSCI EM index as of June 30 are Alibaba Group, Tencent Holdings, Taiwan Semiconductor Manufacturing, Samsung Electronics and Naspers, the only non-Asian company in the group, an internet company based in South Africa.

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