This is a guest post from Pure Portfolios associate Robert Okada, CFA. The following post was featured on Seeking Alpha.
COVID-19 has ignited a movement to diversify global supply chains away from China. Countries within Emerging Asia stand to reap most of the benefits via enhanced direct investment.
GMO research highlights a greater than 13% differential in expected annualized real returns favoring value stocks in emerging markets versus large cap stocks in the U.S.
Emerging-market central banks have embarked on government bond buying, a.k.a. quantitative easing, in response to the pandemic. Another policy tool available is the capacity to lower interest rates dramatically.
The coronavirus has exposed corporate America to weak links in global supply chains. As companies seek to reduce dependency on China, let’s examine implications for global investors, and identify those that stand to benefit within emerging and frontier markets.
"Supply chains will also be affected by currency wars, nationalism, and protectionism, which are all on the rise" - Vikram Mansharamani - Author & Lecturer at Harvard University
Bloomberg recently reported “the world’s electronics makers are actively seeking ways to diversify their supply chains.” Apple for example, announced that over-ear AirPods will be manufactured in Vietnam. While private investment group VinaCapital declared that registered foreign direct investment into Vietnam, through May '20, has increased 19.9% to US$10.9 billion even in light of the COVID-19 lockdown.
India also represents a natural destination with its low cost, highly skilled and english speaking workforce, where they already produce 40% of all generic drugs consumed in the U.S. But perhaps just as urgent, companies want access to its growing market of 1.3 billion consumers. Facebook for example, in the midst of the most recent shelter in place, announced a $5.7 billion investment in Reliance Jio, India’s largest telecom company.
For investors, in addition to Vietnam and India, countries such as Indonesia, Taiwan, and Brazil are clear beneficiaries as corporations seek to invest in and diversify global supply chains.
Valuation & Return Forecasts Grossly Favor the Emerging World
Exhibit 1 shows that EM equities are trading at a 55% discount to U.S. stocks based on Shiller’s CAPE ratio. Keep in mind, based on this metric, U.S. stocks are trading within the highest 10% of historical price earnings multiples.
Exhibit 2 below highlights the inverse relationship between the CAPE ratio and future expected returns. As the ratio approaches 30, as in the U.S. currently, returns descend toward zero. For global investors, EM equities currently represent excellent relative value as return forecasts suggest high single to low double-digit returns.
Value Shares in Emerging Markets have been Beaten Down So Low and are Trading at the Second Widest Discount in History to the Broad Market… resulting in a 10% return forecast (Exhibit 3). Many of these companies pay high dividends, with diversified value funds showing yields in excess of 7.5%. These funds also offer excellent alternatives to most sectors within global credit.
Exhibit 4 highlights EM’s outstanding relative performance to U.S. equities a decade ago, only to severely underperform over the most recent ten year period, ending in 2019.
Exhibit 5 shows the same data, but on an annualized basis: the MSCI EM index outperforms the S&P 500 in the 2000-2009 decade by 11%, but underperforms it by 9.8% in the 2010s.
Cheap valuations in emerging markets, combined with higher relative return forecasts and a decade of severe underperformance provides a much more favorable risk/return profile to traditional U.S. large cap stocks.
Asia’s Rising Middle Class Set To Double by 2030, Driving 50% of Future Global Consumption Growth
A McKinsey Global Institute report highlights that Southeast Asia’s rising “consumer class,” those that have passed an income level to support discretionary spending, will likely double to 163 million households, with Indonesia tagged as a top contributor with its favorable working age population. To put the size and growth into context, the U.S. currently has a total of 128 million households, including those designated as working poor, or in poverty.
In addition, e-commerce is booming within Emerging Asia, accounting for over 50% of the world’s total internet users (Exhibit 6). Over the past 3 years, India and Indonesia have led the world in digital adoption with mobile data usage growing 152% annually, more than twice the rate in the United States. Moreover, penetration rates are significantly lower in Asia at 55%, allowing for widespread growth potential. Alternatively in North America, penetration has peaked near 95%.
Country Funds in Indonesia, India and Vietnam have seen little to no growth, while GDP has Ballooned
Market Cap to GDP, often called the "Buffet indicator," is a useful barometer of relative valuation among countries. EM stocks, having been out of favor the past ten years has resulted in huge valuation gaps relative to real growth. In the case of India for example, this metric stands at 53%, its lowest level since the ’08-’09 financial crisis. Conversely in the U.S., after a decade of severe outperformance, this ratio stands at 145%, and is near its all-time high of 153%.
Exhibit 7 highlights a number of funds that show depressed valuations, favorable demographics, benefit from the shift in global supply chains, and hold robust growth profiles. Overall, the funds shown have seen little to no growth over a ten year period, while in most cases GDP has nearly doubled.
European Union Vietnam Free Trade Agreement is an ambitious pact eliminating almost 99 percent of customs duties
Ratified: June 8, 2020
This recent headline characterizes a world moving forward while the U.S, led by President Trump’s aggressive trade policies, undermines and distorts global trade and provides incentive for other countries to seek opportunities elsewhere.
In closing, as the United States' new Cold War with China heats up, and supply chains reorganize and divide, I suggest playing the long game and re-allocating a portion of your portfolio to these aforementioned emerging (VWO,IEMG) and frontier markets (FM). In my opinion, these markets, led by emerging Asia, will reap outperformance and drive the global economy for decades to come.