The next decade could prove to be a particularly good one for emerging market equities if current trends continue, according to Invesco fund manager Justin Leverenz.
Leverenz, chief investment officer at Invesco for developing market equities and manager of the offshore $155.9m Invesco Developing Markets Equity fund, said there are five reasons emerging markets could outperform their peers in developed markets.
Weakness in the US dollar
The first reason, said Leverenz, is the negative correlation between emerging market equities and the US dollar.
Indeed, big structural movements in non-China emerging market equities occur when the US dollar is weak.
“We see all the ingredients for significant US dollar weakness over the next few years, largely a reflection of considerable fiscal stress in the US,” Leverenz said.
Fiscal stress is evident in the surging levels of government debt, which Leverenz said is likely to continue to expand at a “highly unorthodox pace”. Indeed, federal debt grew from almost $17trn in September 2019 to $20trn by June 2020.
“We expect the federal deficit to significantly worsen over the next two-to-three years, even after the pandemic subsides, as the highly contested November presidential elections lead the winning administration to address longstanding grievances associated with socioeconomic inequalities,” he said.
“The right cocktail”
Along with a weak US dollar Leverenz said the current environment of low interest rates and low energy prices will “likely create a situation where foreign capital flows and private investments will be directed towards non-US assets”.
This bodes well for emerging markets, said the manager, as they offer greater potential for growth being constrained by “insufficient domestic savings to fund investments necessary to lift structural growth”.
Leverenz added: “This starts the flywheel witnessed in previous periods of significant emerging market outperformance – foreign capital inflows beget credit creation, which in turn causes capital formation, growth, employment, productivity and significant earnings momentum.”
This will benefit much of Latin America, south-east Asia and sub-Saharan Africa in particular, the emerging markets manager said.
China
Another factor is the potential for a structural bull market in China, according to Leverenz.
Already making up 41 per cent of the MSCI Emerging Markets benchmark and representing 45 per cent of emerging market GDP, the powerhouse could eventually dwarf all other emerging markets entirely, he explained.
Its representation in the benchmark could continue to grow, said the Invesco manager, as the number of outstanding Chinese ‘unicorns’ – companies valued at over $1bn – come to market.
Indices performance over 3yrs
Source: FE Analytics
Recognition of China’s growing strength as a global competitor has been building for several years, but it was made obvious during the coronavirus crisis. Some 10 months on from seeing its first cases of coronavirus China now appears to be firmly on its way to economic recovery.
According to the most recent International Monetary Fund’s (IMF) World Economic Outlook, China/s expected growth for 2020 is predicted to be 1 per cent. It is the only major economy with a positive growth prediction for this year.
Leverenz said: “We believe China is the only significant macro growth story in a very dismal climate for worldwide growth.
“Having generated a plurality of worldwide growth over the past 10 years, China, we believe, will account for more than 50 per cent of total worldwide growth over the next two-to-three years – in our view – and significantly all global growth in 2020.”
Closing the gap with the US
Nevertheless, it’s impossible to discuss China’s growth story without considering the US trade war, said the Invesco manager.
Leverenz said the US-China trade war will continue but will have a knock-on, beneficial effect for China and emerging markets.
The trade war will likely cause high-quality Chinese companies to consider mainland China and Hong Kong as their preferred exchanges for company listings, said Leverenz.
“This is an important turn with wide-ranging consequences that we think will lead to improved quality of companies listed on the exchanges, better investment opportunities for domestic investors and will result in yet another flywheel effect that will boost the performance of Chinese equities,” he explained.
If more companies choose to list on domestic stock exchanges, it means that the domestic emerging markets investor can access these higher-quality companies.
China has one of the highest average household savings, according to the chief investment officer. But, in the past “the highest quality Chinese equities were inaccessible to domestic investors, having been listed predominately overseas”.
In the past public savings were largely invested in infrastructure and private savings into real estate.
Improving accessibility
Improved access to companies is Leverenz’s final case for an emerging market bull market.
Greater accessibility to many Chinese companies has come about as the Hong Kong market has opened up to mainland investors.
Meanwhile, Chinese companies such as Alibaba and JD.com have recently listed at home as a consequence of the mounting political pressure from the US amid the burgeoning trade war.
“With these massive changes in accessibility – and relatively pedestrian real estate prices – we anticipate a tidal wave shift in asset allocation towards equities, analogous to what we witnessed in the US in the 1980-90s when mutual funds democratised equity investing.” Leverenz said.
Leverenz concluded: “We believe the challenging US and global circumstance make a very strong case for emerging market equities that offer a large investment opportunity set and several extraordinary companies with many real options that will manifest over time.
“The emerging market flywheel effect along with the positive developments around Chinese equities certainly bode well for the emerging market equity asset class, which we believe will be among the most attractive investment opportunities over the next decade.”