Clean balance sheets and higher commodity prices could help EM companies become the biggest beneficiaries of the recovery when “cities reopen and aeroplanes fill up again”, say Frank Carroll and Janet Wang, portfolio managers at Oaktree Capital Management.
We believe global stock markets have reached an inflection point: value may finally be dethroning growth. Record-low interest rates and a surge in passive investing helped high-growth stocks outperform equities in traditional value sectors for much of the past decade. And the Covid-19 pandemic only widened this performance gap. But in the last few months, investors have begun rotating away from stocks trading at high multiples toward cheaper, value-oriented names that are more sensitive to the economy’s health.
We believe emerging markets offer an attractive entry point for those looking to join this shift toward value.
This rotation stems from investors’ expectations of a broad global economic rebound. While the pandemic is far from over, the rollout of vaccines has injected optimism into the world economy. We believe inflation, reflation and a rebound in economic activity are likely as lockdowns lift, cities fully reopen, planes fill up, and more workers return to offices.
This backdrop should benefit many of the “unloved” value-biased sectors that make up a large percentage of the EM investment universe. During periods of economic growth, which are usually accompanied by rising interest rates and higher inflation, cyclical sectors such as energy, financials and materials normally outperform more growth-oriented sectors. Additionally, many EM countries that are big commodity exporters should benefit from the slumping dollar. A weaker dollar normally supports commodity prices because most commodities are priced in the US currency.
Stronger than ever
EM companies were mostly well positioned to withstand last year’s global shock and may, consequently, be able to recover quickly due to their clean balance sheets, high free cash flow and record-low capex budgets. Although EM equities have been weighed down by the pandemic, supply chain disruptions and the risk of political interference, many have emerged stronger than ever, boosted by tighter global capacity, higher commodity prices and greater pricing power.
Importantly, China’s economic recovery, which surged after Covid-19 was brought under control, could aid many EM economies. Unlike other major economies, China’s GDP grew in 2020, with a 6.5% year-over-year expansion reported in the fourth quarter. Its economy also grew over 18% year-over-year in the first quarter – a new record – and is expected to expand by over 8% this year, according to a Reuters survey of economists.
EM countries’ paths to full recovery will remain uneven, and challenges are inevitable. This should create inefficiencies and dislocations, which may create opportunities for investors to buy stocks below intrinsic value. Despite the recent rotation, many value stocks remain cheap, based on our assessment, and continue to trade at a wide discount versus their growth peers. Moving forward, we believe these value stocks will benefit from solid earnings growth, macroeconomic improvements, and base effects (i.e., calculations based on weak 2020 quarters).
Against this backdrop, we remain focused on our bottom-up investment process as we seek opportunities to buy attractively priced EM equities in situations where the catalysts for price appreciation are already present. Geopolitical tensions, current Covid-19 crises, and uncertainty about when the pandemic will end remain top of mind, but we’re optimistic that EM economies will be the biggest beneficiaries from the post-pandemic global recovery.
*Frank Carroll is co-portfolio manager, and Janet Wang is assistant portfolio manager of emerging market equities at Oaktree Capital Management.
