EQUITY

What was good for the world was good for the emerging markets in the third quarter of 2020.

Following a
drawdown of nearly
35% in the first
quarter and a sharp
18% recovery in the
second quarter, the
MSCI Emerging
Markets Index rose
9.6% in the third
quarter to climb nearly
all the way back (96%)
to its pre-COVID-19
peak (Exhibit 1).

Emerging markets
owed their positive performance over the past quarter to a global risk-on environment. The
Federal Reserve did its part to inspire investor confidence by announcing in August that it
would be willing to leave interest rates low even if it meant periods of higher inflation.
Investors also cheered the continued re-opening of public spaces around the world.

However, the gains

were hardly
distributed evenly.
The already wide
disparity between
growth and value
stocks grew
considerably.
Indexed back five
years, the gap now
stands at 62%
(Exhibit 2).

Looking more
closely at the third
quarter, just as in the
US, the performance of a few e-commerce and information technology stocks drove
emerging markets. Out of nearly 1,400 securities, just two, Alibaba and Taiwan
Semiconductor, accounted for more than 40% of the index’s returns.
The equity market is climbing rapidly back to pre-COVID heights, but its base of support
deserves a careful look. China is responsible for more than 35% of the market’s performance
since the 23 March bottom, with Korea and Taiwan contributing another 30%.
 North Asia’s market
leadership (Exhibit 3) is no
accident. Of all the countries
represented in the index, they
have the most advanced
technology industries, and
China has well-known, world-
leading internet companies.

The consumer discretionary

and communications
servicessectors, which contain
the largest internet companies,
led the pack (Exhibit 4) in
China. Looking more closely
at these sectors, three stocks — Alibaba, Meituan, and Tencent — were responsible for
nearly 90% of China’s outperformance this year. These stocks alone represented roughly one-
third of the MSCI Emerging Market’s outsized gains in the third quarter.

The divide between the performance of growth and value stocks is at its highest point in five
years. In a reversal of prior trends, the cheaper a stock is, the less investors seem to want it.
Dividing stocks into quintile by valuation, the most expensive stocks have outperformed the
least expensive by more than 115% over the past 10 years.
 Investors are even punishing
the stocks with the highest
dividends, which tend to be
more established, stable
companies. With interest rates
and the cost of capital so low,
investors seem to prefer that
companies take advantage of
low rates to borrow and
reinvest in themselves, driving
higher rates of growth and
potentially reaping higher
rewards than they could by
investing elsewhere, rather
than returning money to
shareholders. Dividing the
market into quintiles by the
size of the dividend payment,
the highest-paying quintile
vastly underperformed the
lowest-paying quintile
(Exhibit 5), by 57.5%.
Investors viewed companies
with high free cash flow yields
with the same scepticism, with
the most proficient cash-
producers (Quintile 1)
underperforming the laggards
(Quintile 4) by 38%.

We believe the best precedent for this sort of market is 2000, the last time growth was
outperforming value at anything close to this level. What followed, of course, was the
collapse of what turned out to be the dot-com bubble, and a whiplash-inducing reversal.
(Another sharp reversal occurred in 2016, though that market was not as extended as either
this one or the one in 2000.) Is this time different? Technology companies with eye-watering
valuations in both emerging markets and developed markets have shown that they can in fact
produce better and better rates of return by investing in themselves, and as such, they have
been a dependable source of growth in a low-growth world.

However, we still hear an echo of the early 1990s in this market. That was when Japanese
equities peaked after a run that made it seem that Japan, Inc. would take over the world. The
market has yet to fully recover. While we do not foresee a 30-year cycle of underperformance
for growth stocks, we do believe that a strong value recovery is a distinct possibility.

Overlooked Value in Financials?

While we believe generally that investors are overplaying their aversion to value stocks, we
see specific reason to be sceptical about the market’s current rejection of financials. Financial
stocks—particularly large banks—have lagged every other sector, but the fundamentals do
not appear to us to justify this level of underperformance.

We believe that unprecedented levels of policy support for banks in the form of liquidity
support (i.e., lower reserve requirements), relaxation in capital requirements, state guarantees
for loans, and debt moratoriums (i.e., grace periods for payments on interest, principal, or
both) have reduced the risk of a major non-performing loan shock. Loan-loss provisions
could peak by year end, supporting the case for an earnings recovery for the financial sector
next year. It will be critical to focus on banks with strong franchises in their markets as well
as healthy capital positions, banks that have been proactive in terms of their provisioning
cycles.

Conclusion

Emerging markets stocks are currently on their way back up, but the foundation supporting
the rise is very narrow indeed, begging the question of how much further growth it can
support. It’s too soon to tell whether a recent global tech sell-off is the beginning of a trend
reversal, but it’s something we will continue to watch closely. We do not believe, however,
that this is exactly like the dot-com boom: The North Asian countries leading the rally have
built truly world-class tech businesses. That these businesses may now be overvalued does
not mean by any stretch that they do not hold long-term value for investors. The only
question is whether they have upended the value premium for good, and only time will tell
what the answer to that query is.

Finally, while COVID-19 has receded a bit from investors’ minds, the pandemic is still under
way, with emerging markets and the United States driving global transmission. Still, most
emerging markets countries and governments have moved away from broad national
lockdowns to restricting movement in specific locations where outbreaks occur. They are
tapering off existing stimulus packages as they focus on re-opening their economies. But we
believe investors would be wise to temper their optimism and keep an open mind about what
is ahead from here: A recent resurgence in Europe indicates that even countries that managed
to minimize transmission are not immune to future outbreaks. The threat of another wave of
the virus in emerging markets, some of which have not yet tamed their first wave, makes the
level of national planning for vaccine development all the more important.
 DEBT

More than six months have passed since emerging markets debt hit its trough. Third quarter
returns were subdued in comparison to the sharp gains in the second quarter, partially due to
the modest sell-off in the final weeks of the quarter. Nonetheless, the blended asset class
earned a respectable return of 1.46% and sovereigns, corporates, and local currency debt all
registered positive gains. Since the end of the first quarter, the asset class has gained nearly
13% and has nearly fully recovered the losses from the first quarter. All segments of
emerging markets debt have earned outsized returns; however, performance has been varied,
highlighting the importance of a flexible investment approach. Selection—among both sub-
asset classes and individual countries—has been the key to investment success.

As one would expect,

investment grade
sovereigns, the least
risky part of the asset
class, significantly
outperformed during
the sell-off and led
during the initial stage
of the recovery
(Exhibit 7).

In fact, investment
grade performance is
back in positive
territory since the start
of the year, though
much of this is due to
the strong rally in US
Treasury yields. Phase 2 of the recovery began at the end of April with investment grade
outperformance giving way to high yield pre-eminence. Since then, high yield has climbed
16%, well ahead of investment grade’s 9% gain over the same period. Local currencies, on
the other hand, did not experience a meaningful uptick in performance until May and have
since been roughly flat.

The strong rally over the past several months has been fuelled by a confluence of factors,
including vastly improved investor sentiment, easing global financial conditions, and ongoing
evidence of a swift global economic recovery. Perhaps one of the best indicators of economic
growth is manufacturing PMI data, which tend to lead GDP by one or two quarters. As we
head into the fourth quarter of 2020, investors are shifting their focus to the growth outlook
for 2021, and PMIs are painting a positive picture, showing a world vaulting out of the
COVID-19-induced economic slump and into a sharp V-shaped recovery (Exhibit 8).
 China PMIs were the first
to bottom in February and
are now leading the
recovery. PMIs in the US,
Europe, and emerging
markets bottomed in April
and have essentially
registered five consecutive
months of improvement.
Moreover, PMIs across the
globe are above 50—the
threshold that indicates
expectations of expansion.
While it is always difficult
to pinpoint inflection
points in
economic data, trends in
PMIs are pointing to a positive growth backdrop for the first half of 2021.

In general, market participants are now focused less on COVID-19 headlines, although the
developments on that front also appear positive. Overall, infection rates have slowed, and the
economic impact of lockdowns has subsided. While some countries are experiencing a
resurgence and have re-implemented partial lockdowns, infection rates in most countries
appear to be past their peak, and the likelihood of a return to the broad-based and prolonged
lockdowns experienced earlier this year seems remote.

Another notable development during the third quarter was the Fed’s shift in its monetary
policy framework. It will now seek to achieve 2% inflation on average over time by allowing
for intentional overshoots of the target rate during expansions. Although the framework has
not resulted in a shift in policy as yet, the change implies that the appropriate fed funds rate
over the business cycle will be lower now than in previous cycles and is likely to remain
anchored near zero for longer than previously expected. On a secular basis, the more dovish
policy is likely to result in lower real rates and a weaker path for the US dollar.

Despite the strong recovery in asset prices, we continue to see pockets of dislocation within
emerging markets debt, and we believe flexibility will continue to be key to continued
investment success in this environment. As valuations reached levels not seen since the
financial crisis, it is advised to begin to add risk to portfolios by increasing investment grade
exposure in countries with the solid balance sheets and strong liquidity profiles needed to
survive a potentially deep and prolonged recession. As conditions improved and the fog of
uncertainty lifted in May, risk usage is increased across portfolios to the maximum level
permitted by internal risk budgets and began rotating down in quality to capture the
dislocation in high yield credit. These proved to be well-timed shifts, and we continue to see
significant return potential in high yield credit at this stage.

From a macro standpoint, we expect a V-shaped recovery in global growth, with Asia and
Europe leading the way. Moreover, we expect growth in emerging markets to rise and the
growth differential with the developed world to widen, a critical factor for emerging markets
outperformance. Financial conditions and central bank policies across the globe remain
supportive. While fundamentals have weakened relative to the last several years, most
countries are in a solid balance sheet position, and we do not expect a material increase in
credit events. Debt-to-GDP ratios will rise next year and fiscal balances will deteriorate, but
the International Monetary Fund’s (IMF) emergency lending facilities have largely mitigated
potential liquidity issues, helping countries bridge the gap to better growth in 2021.
Additionally, we expect improved supply-demand dynamics in oil markets to lead to a more
stable environment for commodity prices.

In a world with roughly

$14 trillion in negative-
yielding fixed income,
high yield emerging
markets sovereign debt
offers very attractive
yields of over 8%.
Additionally, we see
potential for capital
appreciation through
further spread tightening.
Spreads are currently
around 750 basis points
(bps), compared to the
“normal” range over the
past two decades of
between 400 and 630 bps
(Exhibit 9). Undoubtedly, spreads should reflect a premium to historical averages because the
macro outlook is more uncertain and fundamentals are weaker. Nevertheless, our base case
calls for around 100 bps of additional tightening in high yield spreads.

We believe we have yet to enter the final phase of the recovery, which will be characterized
by sustained and substantial local currency appreciation. There is little doubt that emerging
markets currencies are cheap after years of depreciation. However, a catalyst is needed for
currencies to revert to more normal levels from very depressed valuations. We believe we are
in the early stages of a secular shift in the US dollar, and our currency views at this point owe
more to anticipation of US dollar weakness than emerging markets strength. In order for
currencies to outperform, we need to see evidence of “pull” factors such as growth in
emerging markets outperforming that in developed markets and rising real interest rate
differentials between emerging and developed markets. We have yet to see evidence that
either of these things are happening now, but they may well occur in 2021 or later, which
would cause us to take a more bullish stance on emerging markets currencies.

Ultimately, we believe that we are in the early stages of a period of prolonged

outperformance for emerging markets debt and that any significant downside moves could
present another round of attractive buying opportunities.