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Global Emerging Markets: 2020 country allocation review

Monetary easing and a pause in trade tensions helped global growth turn a corner at the start of this year. While the structural growth story for emerging markets remains intact, a potent mix of challenges remain – including the coronavirus, which should depress activity for the first half of this year. Here, we consider our 2020 country allocations for global emerging markets.

Global slowdown averted – but the coronavirus threatens the outlook

Global growth slowed to its lowest level since the financial crisis in 2019, dampened by barriers to trade and a cyclical slowdown in energy, materials and autos. Emerging markets (EMs) were not immune from this: growth slowed in China and India, while Argentina and Turkey were affected by political and financial turbulence.

But things started to look up at the turn of the new decade, as monetary easing seemed to prevent a deeper slowdown. Central banks across the world have reacted aggressively to weak economic activity (see figure 1) and consumer confidence has stayed robust, with tight labour markets supporting wages and consumption.

Figure 1. Central banks turned dovish in 2019

Source: International Monetary Fund, as at February 2020.

The consensus is that the world will avoid a recession this year. However, there are still several risks that cloud the outlook.

  • The US fiscal deficit hit a record $1tn in 2019. Any fiscal consolidation could leave the economy without stimulus at a time when the monetary toolbox is depleted.
  • A further escalation of trade tensions cannot be ruled out, given that competition between the US and China is strategic and extends to technology, military and global influence.
  • Commodity-price inflation has ticked up, which will affect stability in EM consumers of raw materials.
  • While the global debt ratio has fallen since 2017, corporate and government debt is building up and represents a potential fault line.

While the next downturn looks further away than it did a few months ago, the recent flurry of excitement sparked by the uptick in activity could be the last hurrah. The market has assumed that central banks will safeguard them from volatility and that fiscal spending will come to the fore. But unlike monetary policy, fiscal policies move slowly and are constrained by politics.

Moreover, the outbreak of the coronavirus has clouded the outlook. Factory shutdowns and travel restrictions will have a significant impact on output: Chinese GDP is likely to contract in Q1 and could be 0.2-0.4 percentage points lower over the year. Other Asian economies will be badly affected: some Japanese and South Korean car manufacturers have already temporarily closed factories due to lack of supplies from China.

In the long run, there are clearly more potent risks to the global economy. While the coronavirus poses headwinds, the overall impact on global GDP – a reduction of 0.1-0.2 percentage points – is manageable in the long term. Much hinges on Beijing’s response to the epidemic. The government is likely to unleash substantial stimulus into the economy, which should ensure the hit to growth will be temporary.

EMs face the same mixed messages as the global economy. However, the structural growth story remains intact, driven by urbanisation, an aspiring middle class, and digitisation. In the short term, the International Monetary Fund has forecast the growth differential between EMs and developed markets (DMs) will expand from 220bps to 290bps this year.

However, there is still some way to go before EM profit margins return to pre-crisis levels – they are currently 400bps lower than they were in 2008. Having said that, it seems likely that returns have bottomed out and could turn a corner this year.

Figure 2. Are EM profit margins about to turn a corner?

Source: MSCI, I/B/E/S, Refinitiv, HSBC, as at February 2020.

There is also a large valuation gap between EMs and DMs. The price/earnings (PE) ratio for EMs is trading at a 20% discount to that of DMs, while the price/book (PB) discount has widened to over 30%. Unless the book value of EMs has suddenly been overstated, the only justification we can think of is the view that a downturn will do more damage to EMs’ return on equity. Going forward, this above-average discount could afford an opportunity.

While the uptick in activity at the start of the year can’t be ignored, it can largely be explained by ever-looser monetary policy and a (probably transitory) pause in trade tensions. While some EMs are showing signs of green shoots, challenges remain and the coronavirus will prevent a dramatic recovery from taking place in the first half of the year.

Below, we list our country-level asset-allocation decisions for 2020 – and delve into more detail for key countries in the drop-down boxes beneath.

Figure 3. Country weight targets

China Overweight
India Neutral
Taiwan Neutral
Korea Neutral
Indonesia Overweight
Russia Overweight
South Africa Underweight
Turkey Overweight
Brazil Neutral
Peru Overweight
Chile Underweight
Columbia Overweight
Mexico Neutral
Egypt Overweight
Argentina Underweight
Thailand Underweight
Philippines Underweight
Malaysia Underweight
Hungary Overweight
Poland Underweight
Czech Republic Underweight

China: rebalancing needed    

The phase-one US-China trade deal has boosted the outlook for China. Both the official and Markit/Caixin PMIs are in expansionary territory, while South Korean exports – a leading indictor of China’s overseas shipments – contracted by 5.2% in December, an improvement from a six-month run of double-digit declines.

The coronavirus epidemic has somewhat changed the near-term situation and Q1 GDP is likely to contract, while output for the whole year may be 0.2-0.4 percentage points lower. However, the initial impact of viruses tends to be followed by a ‘v-shape’ rebound in output, and activity should resume towards the middle of the year – with the help of government stimulus.

In the long term, China faces more pressing issues and needs to continue to rebalance the economy towards services and consumption. This should result in growth below 6% year-on-year, as the government de-emphasises property development and wasteful infrastructure projects like the Belt and Road initiative.

China’s debt burden is the largest within EM countries, coming in at over 300% of GDP in June 2019. While Beijing has stepped up efforts to curb shadow banking, net borrowing in other sectors has resulted in debt rising to over $40tn.

China’s promotion of state-owned enterprises (SOEs) has also made it difficult for the private sector to access funding, resulting in higher borrowing costs. But while it continues to reaffirm their primacy, China is reforming its SOEs. The State Council has proposed to eliminate outdated production capacity, SOE mergers and enhance management of financial SOE’s assets.

Finally, heavy US tariffs of 25% on $250bn of Chinese goods will act as a drag on exports. Multinational firms are likely to continue their de-risking strategy and move some production out of China, reducing the country’s strength in low-end manufacturing and benefiting south east Asia and Mexico. 

Despite these challenges, China has the sharpest economic vision among all EMs and, unlike India, is not distracted by internal politics. This gives the government the ability to plan for the long term.

China is focusing on urbanisation, transport infrastructure, smart cities and advanced manufacturing and technologies. The country is already leading the way in 5G networks and is fast catching up in areas like artificial intelligence, which will give the country a significant advantage and boost productivity.

Valuation: MSCI China PE is trading +0.7x standard deviations (SD) and PB is +0.6 SD over a 10-year mean. A-shares are trading at their 10-year average level, implying reasonable valuations.

Overweight: The phase-one trade deal puts a near-term floor on trade-related issues, supporting the economy’s near-term prospects. The People’s Bank of China is injecting funds into the economy – it recently cut the reserve requirement ratio – and the manufacturing sector has stabilised. China’s economic vision is smart and is likely to drive annual growth of 4%-6% on a sustainable basis over the medium term.


India: more work to do

Indian economic growth has slowed from 8.2% in 2016 to 5.1% last year, dragged down by a raft of government measures – including demonetisation and the Goods and Services Tax – to clean up the informal economy.

Indian state-owned banks are constrained by bad loans and a lack of growth capital. The non-bank financial crisis in 2018 affected sentiment and while non-bank financial firms do not seem to pose a systemic risk to the economy, several non-bank financial companies are finding it hard to raise funding from the wholesale market.

Almost 60% of India’s economy is made up of services, which have held up better than manufacturing and have helped the economy grow by 4%-5%. However, the credit slump is not yet over, and should the escalation of tensions in the Middle East force oil prices up, India’s current account would be negatively affected. 

And while the recent protests over the new citizenship law have not yet affected the economy, sentiment has been hit and President Modi’s economic leadership is under question.

The government has started to address some of the issues facing the economy and has taken steps to revive investment. In September, the government reduced the corporate-tax rate from 30% to 22% for existing companies, simplifying the system by eliminating all exemptions and bringing India’s tax rate closer to that of south east Asian nations.

The creation of a real-estate fund for last-mile financing will likely also relieve some stress in the sector, while the national infrastructure pipeline revealed details about a $1.4tn programme which will be executed over the next five years. In addition, some labour laws are in the process of being reformed and the government is looking at amending the Electricity Act to make the market for distribution more competitive.

However, a lot more needs to be done to ensure the economy benefits from its demographic dividend and the untapped potential of an enormous informal sector. These include divesting SOEs, reforming land laws, further opening up the economy and reforming bureaucracy.

Valuation: Relative to their long-term mean levels, the MSCI India PE is trading +1.8x SD and PB is +0.45 SD. The index continues to trade at an elevated PE and above its historic premium to EMs.

Neutral: Although the impact of the credit crisis is known, the economy is bottoming out gradually and is unlikely deliver a v-shaped recovery. Structural reforms taking place mean the country is going through some transitory pain, but in the medium-term it is moving in a positive direction towards a formal economy operating in a rules-based framework.

A Bloomberg Economics study of India shows that a period of sustained structural reform tends to boost productivity and growth potential, forecasting that total-factor productivity growth will increase from 3.8% to 4.1% over the next decade.

South Korea: riding on memory

The latest data seem to indicate that the South Korean economy is gradually recovering from the slowdown in China and downturn in the computer-chip market. The US-China trade deal will support tech supply chains in the region, and the much-anticipated recovery in semiconductors and memory chips should boost exports in 2020.

Moreover, below-target inflation means the Bank of Korea has room to ease policy if needed, while policy stimulus in China (South Korea’s largest trading partner) should also provide support.

In response to the sluggish economy, the government announced a record 8% increase in spending in 2020. However, fiscal stimulus last year did little to boost corporate investment and private consumption.

Economists remain sceptical about prospects for 2020, as government spending will mostly create low-quality jobs for the elderly, while significant investment is needed in research and development (R&D) to boost productivity over the long run.

However, the growth plans are aggressive and if the government reforms regulations and limits labour costs the impact on growth should be positive.

Longer term, Korea suffers from low productivity, an ageing population and dependence on cyclical sectors for growth. Given support for the government is low, it seems unlikely that any positive reforms will take place before the legislative elections in April.

Almost 40% of South Korea’s index is composed of Samsung and Hynix – and so is linked to the cyclical memory sector. The consensus view is that the sector has bottomed out after a very weak 2019, and valuations are already reflecting a recovery in earnings with markets trading at mid-cycle multiples.

The market will do well if there is a positive surprise – for example, if demand for DRAM and NAND exceeds expected supply. Server demand is likely to remain strong, while mobile demand will rebound if the 5G cycle turns out to be robust. There are clearly drivers for Korean memory stocks to outperform in 2020.

Industrials and materials make up about 15% of the index and could benefit if the global economy gathers momentum. However, the banking and consumer sectors are likely to remain weak. President Moon’s policies have largely backfired, with few job additions at lower wage levels and a youth unemployment rate at close to 10%.

Valuation: Relative to their long-term mean levels, the index PE is trading +1.1x SD and the PB is trading at -1SD, indicating that earnings have bottomed out. 

Neutral: The near-term prospects for Korea are positive, although they are somewhat reflected in valuations. The global cyclical rebound may cause the index to rise, however it is questionable how sustainable this will be, given problems with the economy and the lack of tangible reforms.

Taiwan: in the right place, but valuations are expensive

The Taiwanese index rose by nearly 30% in 2019, as US companies increasingly sourced goods from Taiwan in order to avoid tariffs imposed on China. Taiwan also benefited from the rise of new technologies like 5G, while China’s efforts to create substitutes for the US components of its tech supply chain has meant that its dependence on Taiwanese technology increased.

Some of these trends are likely to continue this year – and beyond – as China is unlikely to reverse the process of localisation, and semiconductors remain at the heart of major technological developments.

The easing of US-China trade tensions will also help revive stalled investments, especially in the automation sector, where Taiwanese companies are most exposed. A global cyclical rebound should also provide support, given that the economy has a very high correlation with global trade.

But 2020 is likely to be a challenging year politically, given the re-election of the anti-China Democratic Progressive Party. Favourable US policy towards Taiwan will be seen negatively by China, which has vowed to reunite Taiwan with the mainland.

Valuation: Relative to their long-term mean levels, TAMSCI’s PE is trading at +1.3x SD and PB is +1.8x SD.

Neutral: Taiwan’s economy is well positioned, and several companies demonstrate a strong technological advantage in the high-barrier-to-entry tech sector. Taiwan’s PB premium v South Korea has grown from 25% in 2008 to 122% recently, supported in part by a return on equity that is 75% higher. Nonetheless, if the cyclical rebound is shallow and 5G underwhelms, Taiwan will suffer from a derating (note that this is not our base case).

Russia: structural reforms needed

Russia outperformed in 2019 as the risk of sanctions receded and the economy benefited from a rising oil price. Growth is expected to rise from 1% last year to 1.7% in 2020.

While Russia does not have the typical EM problem of twin deficits, household indebtedness is rising, and a large share of income is used to service debt. Although mortgage penetration is low compared to other EMs, the rise in unsecured lending needs to be monitored as it is has led to banking-sector crises elsewhere. Thankfully, the central bank has tightened lending norms, which will slow the rate of growth in retail lending this year.

Economic growth this year is likely to come from a rise in consumption, boosted by public-sector wage hikes and moderating inflation. While retail lending will slow in 2020, borrowing for investment might pick up. In addition, the government is likely to spend on domestic infrastructure projects, although spending will not be as high as earlier anticipated.

In the medium-to-long term, Russia has ambitious projects in the pipeline that could double its growth potential. If implemented well, these projects could improve social conditions and transform the economy into a competitive and digital one.

Part of the focus is on creating physical and digital infrastructure which could add 20bps to GDP in 2020. However, fiscal spending was lower than planned in 2019 and despite its budget surplus, Russia raised VAT to fund its investments. While prudent from a fiscal perspective, this limits their effect on the economy.

Public discontent is rising in response to stagnating living conditions and an authoritarian state, making it an imperative for Russia to invest. The modest expansion in spending may be too little to boost growth and risks an escalation in public discontent which could potentially destabilise the economy.

Russia has a demographic issue which limits the supply of labour, meaning that technology-led productivity is the key to improving its growth potential. This is not easy to achieve and requires structural reforms and investment in infrastructure and R&D.

Russia has carried out several reforms over the past five years – floating the ruble, empowering the central bank to target inflation and channelling energy revenue into reserves – making it resilient to external shocks. However, deeper reforms are needed to accelerate the process of restructuring the economy and reducing the outsized footprint of the state.

Moreover, Russia needs to control corruption and limit brain drain. The geopolitical isolation of Russia is also an issue for its economy: while at present there is limited noise on this front, the risk of sanctions could rise due to the upcoming US elections – particularly if Russia interferes in the process.

Valuation: Relative to their long-term mean levels, the index PE is trading at +0.9x SD and the PB is +1.3x SD. The market is not cheap, and the earnings growth of the index is flat relative to the regional average.

Overweight: Internal political dynamics – i.e. President Putin’s authoritarian rule – and geopolitical isolation are risks. However, the economy is stable, and growth should accelerate in 2020. While the market is expensive relative to its historical average, Russia has room to improve its growth potential by stepping up investments and improving productivity.

The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. Past performance is not a reliable indicator of future results.

For professional investors only. This is a marketing communication. The views and opinions contained herein are those of the Credit team and may not necessarily represent views expressed or reflected in other communications, strategies or products. The information herein is believed to be reliable, but Federated Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Federated Hermes. This document is not investment research and is available to any investment firm wishing to receive it. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.

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