Across markets and asset classes, investors faced challenges and benefited from tailwinds in 2021. Developed market equities shrugged off disruptions from Covid-19 and the threat of inflation, as stimulus continued to flow. By contrast, emerging markets are struggling as regulatory crackdowns shook confidence in China. The pendulum can swing quickly, however, and investors need to be prepared. Four Vontobel investment experts across equities and fixed income discuss where opportunities can be found as prospects shift from developed to emerging markets.
Simon Lue-Fong, Head of Fixed Income: Let’s start with a top-down, big data perspective. Sven, what are your models telling you about where to find the winners going forward?
Sven Schubert, Senior Investment Strategist, Multi Asset Class Boutique: After an astonishing economic recovery – perhaps the strongest and fastest in history – our models are telling us that global growth has peaked and that the pace is slowing. While the environment is still friendly for equity investors and for cyclical assets in general, our models are tilting towards defensive assets. Our working assumption of peak inflation argues for a slowly fading tightening cycle in emerging market regions such as Latin America and Eastern Europe, making the case for hard currency debt, which has compelling risk/return characteristics.
Simon Lue-Fong: Emerging market equities have disappointed this year relative to developed market equities. Matt, why have they underperformed?
Matthew Benkendorf, CIO Quality Growth Boutique: Emerging market equities should not be considered in isolation. Developed market equities – whether in the US or Europe – have performed well. It is not shocking that emerging market returns have lagged this year given this late-cycle burst of activity in developed markets, which continue to captivate investors’ attention, especially those who are focused on near-term returns. However, emerging markets are now poised to provide investors with a good entry point for medium and long-term growth trajectories. Indeed, the stage is set for emerging markets to rebound as we enter 2022 and start to see more challenges in developed markets.
Simon Lue-Fong: China has dominated the headlines recently and investors are paying close attention to reforms. We are seeing companies affected in areas such as housing, education and technology. Thomas, how can investors make sense of the landscape in China today?
Thomas Schaffner, Senior Portfolio Manager, mtx: We were surprised by the market’s reaction since much of the regulation has been underway for quite some time. We were also surprised by the government’s approach in the education sector, especially the tutoring space, where they forced private companies out of the market. As a result, investors are discounting the worst-case scenario with each new regulation, and many stocks are selling off heavily. The situation has been compounded by the fallout from the Chinese real estate company Evergrande.
China’s central bank began tightening policy early this year, which led to an economic slowdown during the second and third quarter. The market is already discounting a negative scenario and we might be close to a turning point where policies become more accommodative. That said, we believe the government’s goal is to strengthen the middle class and broaden the benefits of economic growth and therefore imposed a better regulatory framework; the aim is not to weaken private companies.
Simon Lue-Fong: Do you still believe that there is opportunity for investors in China?
Thomas Schaffner: Yes, of course. Despite the regulatory tightening, the government keeps liberalizing and opening up markets. For example, it continues to push schemes like Stock Connect to give foreign investors better access to Chinese companies and to give Chinese investors better access to opportunities abroad. It is also launching a new stock exchange in Beijing to cater to small and medium-sized enterprises, which is a clear sign that private companies will remain important.
Matthew Benkendorf: China is obviously going through a rough period and perhaps there are more challenges to avoid. But investors need to consider the challenges in the context of the size of the opportunity. There has been a tremendous increase in the company universe, with over 4,000 businesses listed today. And there are good private sector businesses with solid financial structures, strong business models and growth prospects. Investors need to be careful not to approach China with an “on/off switch” mentality, because the off switch would mean missing out on potential opportunities. Investing in China now requires more discernment and deeper research, but the opportunity is still strong.
Simon Lue-Fong: Let’s switch gears to bonds. Wouter, with low yields, low levels of income, and the potential for rising rates, what is your view on fixed income today?
Wouter Van Overfelt, Head of Emerging Market Corporates, Senior Portfolio Manager: Investors are indeed concerned about fixed income and rising rates this year. But as Matt indicated with China, I do think there are more than enough opportunities in the bond market. It adds to diversification if you have both bonds and equity in your portfolio, and then of course rising rates would be bad for fixed income, although not necessarily worse than for equity. But investors can still select companies with improving credit fundamentals. And even in an environment of rising interest rates, yields can go down on a credit security. So, you can still make money in bonds in a rising rate scenario.
Simon Lue-Fong: I've heard you say that emerging market corporate bonds are an investor's paradise, is that true?
Wouter Van Overfelt: It's definitely true. The market is not very efficient, and sometimes prices deviate from what can reasonably be explained by underlying fundamental data. For example, the market doesn't always know how to price new issues in emerging markets. That means that investors who do their homework can identify the winners from the losers. And when they do that properly, they can indeed capture a new issue premium. Also, within fixed income there are sometimes multiple bonds issued by the same issuer. As the market tends to be segmented, it is possible to find bonds with similar credit risk but different spreads.
Simon Lue-Fong: Let’s look at the equity side. Matt, where are you finding opportunities?
Matthew Benkendorf: While near-term volatility and uncertainty persists in some areas, the predominant long-term drivers in emerging markets are unchanged. Opportunity is still tied to the consumer, rising per capita income and economic development. In short, low levels of penetration for certain products and services can increase over time. And there's tremendous investment opportunity around those themes that investors can capitalize on. By contrast, attempting to capture pockets of disruption is difficult because emerging markets are evolving rather quickly.
Simon Lue-Fong: One theme that is starting to captivate the market is the possibility of a growth slowdown. Sven, does a growth slowdown mean a contraction? And what can we do to protect ourselves?
Sven Schubert: While textbooks tell us that a contraction comes after a slowdown, the reality is often different. So, instead of contracting, global and emerging market economies could get a boost from opening up and the loosening of lockdowns. There is a lot of anecdotal evidence that the world economy could regain economic momentum. That's why we are in favor of a balanced portfolio, where equities play a central role. But as I mentioned before, as the risks have increased, adding a bit more to defensive assets in emerging markets, like hard currency, makes sense. That said, I do see a clear chance that we could get a temporary bounce from the improving global economy.
Simon Lue-Fong: We've clearly heard that there are still many opportunities to identify winners, particularly in emerging markets, both in equity and fixed income.