Manraj Sekhon, chief investment officer, Franklin Templeton Emerging Markets Equity

Emerging market (EM) equities have continued their ascent so far this year, though the pace has moderated from the momentum of 2020. EMs in general have shown sustained resilience in managing and adapting to COVID-19. What’s worth noting, however, is a growing divergence between the perceived challenges surrounding these markets and their demonstrated structural strengths. As the rest of 2021 comes into sharper focus, we highlight three key areas that warrant attention—demand, sentiment, and inflation.

Still-Robust Demand

Our meetings with companies across a wide range of industries in EMs have delivered a consistent message—demand remains robust, and the long-term growth drivers are clear. This has been the case even in countries that generated some of the worst COVID-19 headlines in recent months, such as India and Brazil.

India’s second COVID-19 wave has extracted a heavy human toll, which has also negatively impacted its economy. While the human casualties are tragic, the country’s stock market has weathered the crisis well and is up by more than 60%¹in the past year, reflecting the underlying dynamism of its economy and companies. Corporate results have been resilient, and banks’ balance sheets have been remarkably sturdy over this period. Many businesses foresee a strong demand revival following the latest outbreak.

Before the pandemic, India’s government had already begun tough structural reforms, most notably introducing a goods and services tax and cleaning up the banking sector. These changes, coupled with pro-growth central bank policies, have given us visibility on healthy earnings growth in the coming years. The buoyant stock market has also encouraged companies to raise capital and deleverage. We expect listings from high-quality domestic internet companies in areas such as e-commerce and payments, which would boost the industry’s thin stock-market presence—and enlarge the opportunity set for investors seeking exposures to disruptive trends.

Brazil’s equities and currency have enjoyed a late rally, with the stock market rising more than 40%² in the past year. Higher commodity prices and improved economic momentum have helped offset concerns about the country’s fiscal discipline, commitment to economic reforms, and political environment. Political uncertainty has heightened, with support for President Jair Bolsonaro waning amid dissatisfaction with the government’s management of the pandemic. This has paved the way for former President Luiz Inacio Lula da Silva to emerge as a challenger in the lead-up to next year’s presidential election.

On the economic front, however, Brazil’s public finances have been improving, with reforms remaining high on the country’s agenda. The government has been progressing with privatizations and the auction of infrastructure concessions. These reforms, together with tax and administrative changes in the pipeline, should bear fruit in the form of higher-than-expected economic growth in the longer term.

Across India, Brazil, and other major EMs, technology’s role as a key economic engine has only strengthened during the pandemic. Many companies have adapted swiftly to an increasingly contactless world, bringing forward digital transformation to draw consumers and lift productivity. The semiconductor industry is experiencing a cyclical and secular boom as growing digitalization powers a surge in demand, while COVID-19 continues to drive a global supply shortage. This environment means likely multiyear growth for chip makers in Taiwan and South Korea that have come to dominate the global industry with their superior technologies and investment scale.

China has also been climbing the technology hardware value chain as it prioritizes innovation and self-sufficiency in its longer-term development plans. Chinese companies that succeeded in their upgrades have won market share globally at a time when COVID-19 hobbled their overseas competitors. We also find innovation-centric businesses in the electric vehicle (EV) and solar energy industries well-positioned for longer-term growth as EV adoption and decarbonization gains momentum around the world.

Shifting Sentiment

The healthy demand picture we have seen on the ground contrasts with the soft sentiment that has surrounded EMs amid new COVID-19 outbreaks slow vaccination progress, and other country-specific concerns. We expect this backdrop to set emerging economies up for better performance ahead as vaccination rates and COVID-19 trends improve.

India’s government has accelerated its vaccine rollout, and we expect rising vaccination rates to support the economy’s return to recovery. Across EMs, vaccination programs are ramping up, which should enable further economic reopenings. This is good news especially for tourism-reliant countries such as Thailand. Mobility-dependent companies should also start to catch up with the broader market advance as economic normalization translates into earnings recoveries.

China, a major outperformer in the EM equity universe until February this year, has fallen behind its peers. Internet heavyweights have been a drag as the Chinese government stepped up its regulatory scrutiny of the industry through antitrust measures and other rules. Major internet players have pledged to increase spending to boost their competitiveness. We view the weakness in these stocks as a short-term pause rather than a longer-term pullback. Crucially, we see the government aiming for the sustainable development of an industry that contributes significantly to the country’s economic growth and technological progress. We expect these stocks to resume their momentum as the regulatory pressure recedes and as business investments complete, and we remain constructive about their longer-term potential.

Rising Inflation Risk?

Inflation concerns in the United States have reemerged as a stimulus-fueled global economy springs back from the depths of the pandemic. Even as we stay true to our bottom-up and stock-driven investment approach, we remain vigilant about possible macroeconomic headwinds. The US Federal Reserve’s (Fed’s) latest views reflect its concerns around:

• Higher inflation
• An extended transitory period of elevated prices
• Bringing forward the start of tapering to 2022
• Earlier-than-expected interest-rate increases from 2023.

The recent shift in the Fed’s tone on inflation reflects the solid demand backdrop that we have observed. The price hikes reflect rising commodity prices, supply bottlenecks, and pent-up demand—an interplay of factors unique to the pandemic. Many EM companies have been measured about passing on higher input costs to customers, recognizing that much of the increase stems from near-term supply disruptions. Efficiency gains and competition among companies have also kept prices in check. Our view is that inflationary pressures will be relatively short-lived.

Conversely, experience suggests that the Fed’s messaging around tapering and preparations for such a move are likely to create more market volatility than the actual reduction of bond purchases. The real risk will be abrupt liquidity withdrawal on expectations of rate rises and the end of unprecedented stimulus, which could bring about more market caution. Higher rates could also trigger a strengthening of the US dollar, which is potentially negative for EMs such as Indonesia with twin deficits in their fiscal and current accounts, though we note that there are much fewer significant emerging economies in this situation today. Given the extraordinary liquidity backdrop that has driven the strong risk appetite in markets, we could see more volatility between now and year end.

Charting a Path Forward

As a whole, EM economic fundamentals have improved in the past decade, and we believe they are in a stronger position today to cope with any market volatility. Our overall outlook for EMs remains positive as they continue to chart a path out of the pandemic, though some risks may impact our medium-term view. That said, short-term air pockets could create longer-term investment opportunities, underpinned by EMs’ structural strengths and the competitiveness of their companies.

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. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.

Sources:

1. Source: MSCI India Index, in US dollars, over a one-year period, as of June 15, 2021. 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.

2. Source: MSCI Brazil Index, in US dollars, over a one-year period, as of June 15, 2021. 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.