Active Thinking

At GAM Investments’ latest active thinking forum, three of our brightest investment minds discussed an improved outlook for emerging markets equities, the factors influencing the healthcare sector and the bottoming of China’s credit pulse.

22 February 2022

Tim Love - Emerging Markets Equities

Why should we be looking at emerging markets (EM) now? The magnitude of the drawdown of EM assets and the magnitude of the return profile could not be more chalk and cheese. The asset class is demonstrating resilient earnings; for example, the MSCI Emerging Markets Index is looking at earnings of around 9 – 10%. We are already seeing a price/earnings ratio (PER) in this asset class in the range of 11. Furthermore, there are a lot of other aspects which are remarkably positive, such as the composition of the index becoming much more new world economy, much more ESG and much more likely to encourage a multiple re-rating from crossover monies, from search to yield monies and from value monies. Price to book on many of our stocks, especially in the property sector and banks, are materially under one. In many cases, they are benefiting from having dividend yields higher than PERs.

EM equities have not had a bull market for 15 years. Instead, they have consistently de-rated. As a result, the prospective multiple expansion probability is significant. The reasons lie in improved liquidity and investment grade opportunities; most of the poorer members of the asset class have been removed from the index. Meanwhile, 72% of the asset class is comprised of China, South Korea, Taiwan and India, which are all investment grade. This means the noise and the volatility of the asset class have gone and instead, within these top four countries are a lot of new world companies. They are essentially developed world companies, such as TSMC and Samsung, operating from emerging markets. In that sense, the rate of change of delta when they address governance and sustainable aspects will likely then become a flood of interest that has previously not been open to that jurisdiction. The risk / return quadrant is turning from having a lot of downside in a volatile trap door kind of asset class with poor investment grades or no investment grades to one which is dominated by investment grades, liquidity, ESG change, with domestic demand and with policy support. As a result of all this, it also gives potentially materially less downside than that of the developed world.

The changed composition of the asset class is an opportunity to play value in a higher CPI environment. The top GARP plays have already been de-rated by 60 – 70% on China regulation and will act as coiled springs when there is an abating of negative winds against them. Value will run as an inflation hedge, and as a commodity play and a positive carry trade.

Furthermore, the START stocks (Samsung, TSMC, Alibaba, Reliance, Tencent) are beginning to rally versus FAANG stocks year-to-date. Given they are such large parts of their respective indices, we think there is potential to generate a lot of alpha. The valuation on START stocks is very low because Tencent and Alibaba were crushed by policy last year. The recent positive revisions on companies such as TSMC are remarkably high. The last period of such sustained underperformance was following the tech crisis in 2000. EM then caught up to developed markets in 2004 – 2008, during which period they generated four times returns in three years. We are currently at a cheaper entrance point now, but with better earnings, better governance (both at top-down sovereign and at stock level), with better free cash flow yields, sustainable domestic demand and favourable policy support. Additionally, the asset class is supported by small amounts of debt to GDP, compared to that of the developed world. The top four countries in the EM index are not only investment grade, but as good investment grades as the developed world and with only one third of the debt.

Jenna Denyes – Healthcare Equities

In general, within the healthcare space most of the subsectors are down year to date. There are a few negative drivers, with inflation and some other sector-specific factors being influential. The first of these is the big shift from more high-risk biotech into areas which are defensive against the macroeconomic situation. Second, there has also been a run of neutral to negative news flow from clinical trial results, which we view as statistical anomalies, that have caused pauses and delays. Despite 2020 and 2021 seeing a record numbers of initial public offerings (IPO), we have not seen the typical merger and acquisition (M&A) activity in the space we would expect, so this is yet another influential factor. This is causing early-stage companies to occupy a lot of space in the market and making things crowded. Finally, the large rush of generalist investors towards the beginning of the pandemic are now departing the sector, making it look more negative. The disruption in the small to mid-cap biotech indices saw a fall off in 2021 as people realised most clinical programmes take longer than six months to reach drug approval. With long timelines and boring trial periods, people lost interest in investing and moved into different areas with shorter milestone timelines. While generalist investors leaving the sector has caused a large correction, we see this as an overall positive, with a return to more realistic valuations and overall a reset back to where the sector was in 2019.

In order to see recovery, macroeconomic stabilisation is important, alongside a return to normality within healthcare; surgery activity, doctors’ appointments and patient comfort with returning to hospitals all contribute to this. Positive news flow and consolidation through M&As will also help with recovery. It is difficult to assess if this has already started; many of the recovery factors are still unclear, however, the present shift from pandemic to endemic means things are normalising in that respect.

We anticipate a bumpy first half of 2022. However, with a continued normalisation of both the pandemic situation and the sentiments of the news flow in the sector, we are cautiously optimistic the second half of 2022 should see a return to stability and then a return to growth.

Rob Mumford – China Equities

We believe there are two key elephants in the room regarding emerging market (EM) equities this year; first, how much China loosens policy and second, how much the US tightens. We are positive on the easing pace of China; the speed and scope of the tightening adjustments last year went beyond expectations and the authorities are now forcefully moving the other way. In the US, while there has been an increasing tightening trend, we think Asian markets with China at its core are well positioned for this shift.

Three key elements made for a difficult year in 2021 for China equities. The fiscal and monetary contraction, the regulatory shift and lastly, external events, particularly the energy shortage and Covid. With the property market under stress, the trend in economic growth momentum was very weak, with retail sales rising just 1.7% year on year (yoy) in December 2021.

As a result, in December 2021 a key working group headed by the top leadership made a clear signal of policy shifting to an easing stance, with sustaining growth being the key target. Some believe the priorities of a social political agenda, including dual circulation and common prosperity, may preclude any urgency to deal with the current negative economic trends in growth. However, we believe that with both systemic risks (including unforeseen outcomes of property de-leveraging) and unemployment risks from last year’s cyclical and regulatory adjustments, a more pro-growth agenda could likely emerge this year into the leadership transition sessions, which will occur later in 2022.

With two reserve requirement cuts, two interest rate cuts so far and additional liquidity provided to the system, China’s credit pulse appears to have bottomed. More fiscal support is expected to emerge around the twin parliamentary sessions due to start in March. China has gone through a full contractionary cycle and has shifted to an expansionary phase similar to 2019, we believe it is well positioned as the rest of the world starts to tighten.

While the shift in tone of US policy has become increasingly hawkish, there are a few positives from an EM perspective. Even on a revised hike schedule, US real rates are expected to stay low for some time. The recent range bound action of the US dollar reflects this, as other currencies with strong recovery growth and higher real yields are performing better. It is also encouraging to see distant proxies for US inflation start to ease versus nearer term indicators, for example US Treasury five-year break-even rates versus the two-year. This implies there may be a transitory element to the current levels, with an end to Covid providing some easing for supply side inflation pressures. Pre-emptive rate hikes across a number of emerging economies puts them in a strong position, with real rate differentials versus the US at highs while externals balances, including current account deficits, are also much stronger compared to a few years ago. China again provides an interesting contrast with the US, with January 2022 consumer price index (CPI) actually coming in below expectations at 0.9% year-on-year (yoy) versus forecasts of 1% yoy and December’s 1.5% yoy. It is an example that inflationary pressure across China and much of Asia is much less pressing than in the developed world, with higher bases and much lower wage pressure. On current (Bloomberg) consensus forecasts central bank rates across Asia ex-Japan are only expected to rise from 3.72% in 2021 to 3.9% over 2022. Meanwhile, real GDP growth is expected to maintain at an elevated 5.5% and only slip to 5.1% in 2023.

The net result of this trend of strong growth and less pressure from rising discount rates puts the EM equity markets in a good position, assuming US tightening does not get even more aggressive leading to elevated volatility spreading to all asset classes.