Q4 2021 CIO Review and Outlook
CIO Robert Horrocks, PhD, sees promise and opportunity in the Emerging Markets in the wake of 2021’s headwinds.
2021 was a difficult year for Asia’s markets and for much of emerging markets in general. Normally, a reflationary environment would be considered good for our markets. However, several factors combined to provide some serious headwinds.
First, there was the switch from “growth” to “value.” Now, these terms are much argued over and it often becomes a game of semantics. More accurately put, it was an environment where cyclical stocks with low valuations and often marginal business models in sectors like raw materials, banks, and industrials tended to perform rather well. This caused headwinds because many of these sectors do not necessarily perform well over the long run. North Asian banks are generally low quality. Many industrials struggle to achieve economic moats and are often in vulnerable parts of the global supply chains. The majority of raw materials companies are price takers and lack economies of scale. However, these sectors may all have their day in the sun.
The “value” rally only lasted for about half the year—as soon as the yield curve started to flatten again, as fears grew over tightening by the Federal Reserve, some of these more cyclical stocks started to falter.
The second headwind was the after effects of China’s regulatory decisions. The press has liked to use words like “crackdowns” when, in truth, the reasons for the actions were, for example, to try and safeguard equal access to education in core subjects. Or, to ensure that online platforms didn’t use their power to create anti-competitive practices that would harm the consumer. In other areas, such as data privacy, the authorities have acted in a way that significantly lessens the ability of companies to profit from the client information they have.
These measures are not entirely different to some that were taken in the past in China in areas such as health care and nutrition. Nor are the ideas behind them too different to those that underlie the concerns of many in Western countries about social media and online retail. However, the process of implementation in China is short on consultation and the lack of checks and balances means that action can be as abrupt as it is effective at curbing the excesses. And then we have the problems of unintended consequences—we have seen past reforms in health care and in fossil fuels adjusted so as to mitigate some of these adverse effects.
Consternation in the media that these moves were an attack on private enterprise and innovation seems to lack much foundation in the evidence. Nor is it, from a philosophical or pragmatic point of view, easy to see how an attack on private enterprise would meet either the needs of the Chinese Communist Party or the needs of China’s citizens whose interests the government is trying to protect.
All of this meant that, for 2021 at least, investors found better returns outside of China. One might have thought that with the rise in raw material costs, Latin America was the place to look. And so it might have been, were it not for some of the political and budgetary issues that prevented Brazil, for example, from posting better returns. Similarly, Chile never really experienced a significant rebound and it remained in the doldrums. Instead, it was Mexico that proved the most resilient among Latin countries, benefiting, I suspect, from the discipline it has shown the government budget and current account. The economy is now experiencing some of the surge in core inflation that is worrying developed market central bankers but it’s at least providing a solid environment within which investors can seek good companies.
The real winner from raw material prices was to be found outside Latin America, in Russia. It is frequently the case that Russia moves in different cycles as a stock market to China—but this was a year of dramatic differences. Its performance also seemed to warm the stock markets of Eastern Europe. However, as with Mexico, rising inflation in Russia is concerning.
Whilst the preponderance of evidence still suggests that spiking inflation is largely transitory (while the duration and scale is uncertain), the swiftness of the rise has provoked central banks into thinking that speed limits may have been breached. The general inflationary environment may be more important that commodity prices anyway. Look at Japan, for example. Although it might have felt the pinch from rioting raw material costs, the economy was nevertheless able to enjoy reasonably strong performance from the revitalization of industry amidst a global inventory rebuild. The overall reflationary environment outweighed mere cost increases and, still, Japan’s market remains one of Asia’s cheapest.
Whatever Mexico has been able to achieve, so has India. The current account was brought into surplus and the inflation rate was somewhat tamed. Couple these achievements with a much improved export performance, particularly to ASEAN and Latin America, along with success in some industrial exports such as the automotive sector, and India had a banner year. These conditions propelled earnings growth and stabilized the currency. They also gave us a glimpse of the sort of outperformance that can be possible if the reforms to its economy, notably the banking system and the physical infrastructure, are to succeed. The most notable achievement of India, so far, is that inflation has risen only moderately. Who knows if this is to be sustained. However, it is the best hope if the extraordinary outperformance of India relative to China this year is to persist into 2022.
And what do we fear in 2022? And what do we hope for? We fear a Fed that tightens too aggressively in the face of transitory inflation. And we fear a Fed that is forced to tighten even more aggressively because inflation turns out to be more sustained. Above all, we fear that this may be far too difficult a job for any central banker to manage perfectly.
On the other hand, we hope for reflation in China. While most of the headlines focused on the actions of regulators last year, much of the story in China was due to tight monetary policy and controls over the credit market. As these controls loosen, we shall see how big a factor they were in 2021 and how they might drive returns in 2022.
As I look across Asia, I see reasons for optimism. The management of the pandemic has been pretty sensible and the environment for private entrepreneurship remains strong—yes, even in China, where like much of the rest of the region, small companies performed quite well relative to large caps in 2021. And despite the fact that some of the more exciting businesses saw their stock prices hit hard, it is still within these sectors of the future—technology, health care, consumer and services—that we find the best expression of Asia and emerging markets’ domestic demand growth.
Finding sustainably-growing quality franchises in these areas remains our focus; fortunately, the opportunity set of such businesses continues to expand. We have had our share of volatility but our markets are changing rapidly, as new consumer preferences and emerging technologies change the investment opportunity. These are exciting times!
Robert Horrocks, PhD
Chief Investment Officer