Comment on Q3 2021: Keeping up with demand
As an eventful 2020 concluded, we released our 2021 outlook with a positive view on the economy, emerging and frontier markets as an asset class, and equities in general. With a quarter of the new year now having passed, much of what we argued for still holds true.
Fiscal and monetary policy remains expansionary, and we have received further confirmation on the strong momentum in the underlying economy, with the IMF now expecting global growth of 6%, led by the US and China, which are expected to grow by 6.4% and 8.4% respectively. And while these figures themselves are remarkable, the realised growth may surprise further on the upside. In the US alone, households accumulated an enormous 1.6 trillion dollars last year as they received stimulus checks and tax credits with limited ways to spend when the economy was under lockdown. Should the re-opening prove successful, and a large part of these savings turn into real demand, growth in the US could exceed 10%. This bodes well for both service and manufacturing companies, and will likely increase US imports from the rest of the world. A sharp increase in demand does however come with a caveat. If the supply chains do not hold up, we are likely to see price inflation, and some data is now pointing in that direction. Container shipping rates between Asia and Europe have risen three-fold since the third quarter last year, and the semi-conductor industry is running at full speed, struggling to meet demand, which has hurt the auto sector among others. Risks to the supply chain are not all demand related. Most recently, a stranded ship in the Suez Canal put a temporary halt to the 12% or so of global trade that goes through there daily, highlighting the fragility of globalisation.
The implications of higher inflation are many, but as an emerging and frontier markets asset manager we focus on two factors. Firstly, higher inflation has a significant impact on the relative performance of sectors and companies. The main beneficiaries are financials and companies with pricing power, but also cyclical assets in general. Those hit harder are defensive assets, such as utilities and some real estate names, but also tech stocks whose future cash flows become discounted at a higher rate. Secondly, higher inflation may trigger central banks to tighten sooner rather than later, implying higher yields. This could prove to be a headwind for some emerging markets.
However, while higher inflation expectations and yields have materialised to some extent, it is too early to tell whether they will be sustained. Many of the leading central bank economists argue for any inflation pressure to be transitory. Furthermore, higher yields are not necessarily a negative sign, as they can also be a receipt for economic health. We therefore continue to look optimistically on equities but remain vigilant on future developments, with a continued emphasis on active management and stock selection. Our global presence within emerging and frontier markets continually presents us with many exciting investment opportunities. As an example from the semi-conductor industry, the largest chip foundry in the world and a portfolio investment of ours, TSMC, resides in Taiwan and offers a pure play exposure to an ever-increasing chip demand. In Russia, steel prices at record highs have made some companies now offer a dividend yield above 20%, paid for by free cash flow, which is likely not easily found elsewhere in the world. And in China, world leading renewable companies can still be bought at earnings multiples around 15x.
Looking at performance during the first quarter, MSCI Emerging Markets and MSCI Frontier Markets gained 2.5% and 1.3% respectively. What stood out on the upside was semi-conductor and car producing countries, with Taiwan up +10.5% and South Korea +2.9%, as well as commodity-exposed countries, with South Africa up +11.6% and Russia +6.6%. On the downside, Brazil and Turkey declined by 10.8% and 14.4% respectively, as domestic politics dampened investor sentiment. In Brazil, one of the key events was a move by president Bolsonaro to replace the investor-friendly CEO of government-owned Petrobras, while in Turkey, PM Erdogan decided to sack the central bank governor, despite his strong progress in regaining investors’ trust. In China, the year offered a slightly softer start, with China H shares up +0.1% and China A -1.8%, partly weaker as looming regulations and policy normalisation made headwinds. Our funds continued to do well in the current environment, both in absolute and relative terms, delivering alpha of up to 5.2%.
Looking ahead, we remain positive on our outlook, and expect equities to be supported by the underlying strength of the economy, though we remain aware of the uncertainties ahead. In particular, too large an increase in inflation may cause some market volatility, and we are not yet out of the woods when it comes to the pandemic, even if it is very encouraging to see the progress made by the countries that are leading in terms of vaccination, such as Israel and the UK. Also, geopolitical risk remains, where the US rhetoric is still tough on both China and Russia, and we do not expect this to change soon.
