Comment on Q2 2021: Faster growth, higher inflation
When companies, investors and economists alike review growth or change momentum, this is often done by looking at year-on-year figures. As a result, the trough from the pandemic, which occurred during the first half of last year, combined with the recent easing of restrictions thanks to rising vaccination rates, has resulted in record high growth numbers for GDP and earnings, not seen in decades.
For 2Q 2021 GDP, forecasts now imply year-on-year growth of around 10% for both emerging and developing markets. In terms of second quarter earnings, the forecasts point to a staggering 70% year-on-year growth for MSCI Emerging Markets and 85% for MSCI Frontier Markets. These numbers, combined with the benign fiscal and monetary policy environment, have made it easy for stocks to find higher ground.
For investors, this has resulted in a renewed enthusiasm for cyclical and value stocks that have been well positioned to capture the above-mentioned trends, which has also benefitted many of our strategies. As one example, our financial exposure within Eastern Europe has seen broad-based gains. Both among the traditional banks, where many have gained more than 30% TYD, but also for fin-tech companies, where Russia’s TCS Group and Kazakhstan’s Kazpi.kz are now up 178% and 65% respectively. Another example includes the cost-efficient Russian commodity producers. Rising commodity prices have generated windfall gains, and several companies now offer double-digit dividend yields, while trading at very attractive valuations.For geopolitics, the picture this quarter has been mixed. The US and China’s relationship continues to see tensions, and the US in June imposed trade bans on Chinese companies within the solar panel industry over forced labour concerns, while NATO proclaimed China a potential security risk. Taiwan is in the crosshairs of these tensions as China wants to reunite the region with its mainland, while the US supports the country’s self-rule, especially given that Taiwan is a key player in the global semi-conductor market.
For the Russian market, geopolitical risk has declined materially, especially considering Russia removed the troops amassed at the Ukraine border just 3 months ago, after Biden and Putin met in Geneva where talks were deemed constructive, and France and Germany followed up with a push to reset the relationship between EU and Russia. We discussed this during a webinar together with our Senior Advisor Anders Borg and our Moscow-based colleague Jacob Grapengiesser.
Looking at performance during the second quarter, MSCI Emerging Markets and MSCI Frontier Markets gained 5.1% and 14.1% respectively. Within emerging markets, those with cyclical exposure generally did well, with Brazil up 23.4%, Poland gaining 18.6% and Russia up 13.4%. Taiwan continued to perform and gained 10.8%. China traded slightly higher, with China A up 8.6% and China H up 2.3%, while Turkey remained in the doldrums and fell 6.5%. Within frontier markets, most markets posted double-digit gains, while Nigeria and Egypt saw minor negative returns. The frontier markets index also saw the addition of Iceland this quarter, when the country joined with a significant index weight of 8%. It is now the third largest market after Vietnam and Morocco. While this might seem odd given that Iceland enjoys a GDP per capita of USD 65,000 compared to USD 2,100 in Bangladesh, it is worth highlighting that the frontier index also reflects liquidity and market access for international investors, which is what Iceland is lacking compared to its Nordic peers.
Among our funds, those exposed to Eastern Europe did very well and outperformed broader emerging markets. East Capital Frontier Markets delivered a strong absolute return. In April, the fund was awarded the Lipper prize for best European fund for the past three years in the frontier markets equity category. Strategies exposed to Asia delivered muted figures, partly on regulatory worries towards the tech sector.
With this rather historical period behind us, what lies ahead?
As we move into the third quarter, the supporting base effect from last year will start to fade, which implies the easy comparisons are soon gone, and GDP and earnings growth should gradually return to levels more in line with historical averages. Through the bigger lens, this means that at least in terms of momentum, we are now at or close to the peak. On inflation, it remains a potential market risk, and in May, the US saw consumer prices rise 5%, the highest hike since 2008, though we are finally seeing some indication of supply-chain bottlenecks easing.
While this might appear a weak backdrop, growth should remain above trend for at least a couple of years, and with fiscal and monetary policy still rather loose, we continue to believe this will be a good year for emerging and frontier markets. Prospects for our portfolio companies’ earnings growth look solid in absolute terms and strong compared to developed markets, while relative valuation is very attractive, with MSCI EM now at a 37% discount to the S&P 500. And for those investors seeking income and value with cyclical exposure, Russia offers a great opportunity, with our fund now trading at an almost 9% dividend yield for this year at a valuation of P/E 6.9, not something easily found elsewhere.
