04.20.21

“Going viral” has taken on several new meanings over the years. In a world where we are confronted with an actual virus and businesses that thrive from the phenomenon of going viral over digital platforms, we have faced both serious societal challenges and investment opportunity all at once. Have both phenomena run their course? While we lack a crystal ball, in our opinion, the future is bright. In many ways, this is particularly true for emerging markets.

Now and then

From 30,000 ft. to important long-term characteristics, current fundamentals and common objections, we believe emerging markets is an area investors should see as a capital appreciation solution now and for the future.

Underlying Fundamentals

Valuation: In the current environment, where earnings have been severely depressed and volatile, we believe a fair valuation metric to review for relative comparisons is the Cyclically Adjusted P/E ratio (CAPE), also known as the long-term P/E ratio.

CYCLICALLY ADJUSTED P/E RATIO (CAPE)

Generally, global equities are currently above their long-term average CAPE ratio. But non-U.S. equities are relatively less expensive in both an absolute and historical context. While valuation is important, on a stand alone basis, it isn’t necessarily predictive, which brings us to growth.

Growth: With COVID-19, the scarcity of growth has generally led to a greater premium in areas where it is strongest and most sustainable. Much like we have seen on an individual stock basis in recent years where growth has commanded a significant premium, regions of the world have experienced the same through the pandemic. A growth advantage may continue to favor emerging market equities.

GDP AND EPS GROWTH

	2020
	GDP Growth (%)	Earnings Growth (%)
U.S.	-3.4	-8.4
China	2.3	5.0
Europe	-7.2	-28.7
Emerging Markets	-2.4	-4.9

	2021E
	GDP Growth (%)	Earnings Growth (%)
U.S.	5.1	22.7
China	8.1	16.9
Europe	4.2	35.4
Emerging Markets	6.3	36.9

	2022E
	GDP Growth (%)	Earnings Growth (%)
U.S.	2.5	14.3
China	5.6	17.3
Europe	3.6	15.2
Emerging Markets	5.0	15.2

Source: GDP Growth: International Monetary Fund, 2/28/2021 Earnings Growth (MSCI indices): Thomson Reuters I/B/E/S. Past performance is no guarantee of future results.

On the world stage, emerging market equities have a long runway. They still represent a mere 13.7% of global equity market cap, yet have far greater significance to world output and future growth.

Valuation and growth can be powerful predictive characteristics. This, along with greater prevalence within the global economy, bodes well for emerging markets. It is a good recipe for long-term capital appreciation. However, the world is rapidly changing. Investing in businesses on the right side of that change is important. So naturally one should ask: When investing in emerging markets, what am I investing in?

Like the U.S., in emerging markets innovative technologies, consumer platforms, and business models have been the focal point for investors. Those companies that can create and implement innovation have generated superior economic value. With COVID-19, many of these innovative trends have accelerated and will likely succeed in a sustainable manner for many years.

Innovation: Creation and adoption

In the developing world, technology and innovation leaders have emerged, an ambitious population and increased social mobility drives entrepreneurship, and a large consumer base has adopted technology quicker than developed world consumers.

Innovation vs. Market Capitalization — Unicorns, a term that refers to private companies with market values greater than $1 billion, are considered the “nursery” for future innovation leaders and soon-to-be public companies (IPOs). This bodes well for the future growth and expanding investment universe in emerging markets.

If the future of corporate growth is largely grounded in the creation and adoption of technology, then we believe emerging markets is a prime area of the world to invest in such growth. It is home to many of the world’s most innovative up-and-coming companies.

As a long-term investor, it is important to understand the characteristics that can drive trends sustainably into the future. For example, if the U.S. implements more stringent IP protection against China, will that lead to a decline in their ability to innovate? Several statistics point to the ongoing ability for China to create and continue their path of entrepreneurial success across several industries.

Patent Applications by Country (2018)

Source: WIPO — World Intellectual Property Indicators 2019.

Countries with the most STEM graduates (2016)

Source: World Economic Forum.

China accounts for nearly half the patent applications in the world. It is also home to the most graduates from science, technology, engineering and mathematics (STEM) programs. This will enable them to continue to develop globally competitive technology and medicine. Areas where we are likely to see them thrive for many years ahead.

Growing wealth of the middle class, millennials and adoption of technology: Emerging markets is home to the largest consumer base in the world. One that continues to grow in size and wealth. It is also a population that has adopted technology. Companies with a competitive edge, particularly those with the ability to reach their consumers through smartphones, seem to be well positioned.

Smartphone trends favorable in emerging markets

Source: World Economic Forum.

The virus may have long-term fiscal effects

How will it impact emerging markets? When the world came to a screeching halt in March 2020, governments and central banks stepped in to support major economies. Essentially, bridging the economy from one side of the abyss to the other. Countries in each area of the world took different approaches toward handling of the virus and, as a result, their approach to government support as well. These decisions could have lasting effects.

To distance or lockdown?
In select Asian countries, extreme lockdown measures at the early stages of the virus resulted in containing the spread. This allowed these economies to get back to a more “normalized” state when compared to societies that encouraged behavior and set certain restrictions, but was moderate in enforcement.

14 Day COVID-19 cases - per 100k

Source: European Center of Disease Control; as of 12/31/20

Long-term impacts?
Many of the long-term effects from the pandemic will emerge over the coming years, but certain symptoms are already evident. Excessive spending in developed countries is manageable, but may prove to be a long-term constraint.

Emerging Markets: Objections to investing in the region

Emerging markets is a cyclical, commodity driven market that benefited from China’s growth and infrastructure boom, but China’s growth is slowing: China is decelerating, but it is still the second largest economy in the world. Growth of just 4% creates a meaningful amount of economic activity, adding roughly the equivalent of Sweden’s annual GDP. Also, emerging markets has a different investment case than it did 20 years ago, with the innovation boom and also supported by the evolving investment landscape.

The evolving investment landscape — 2000 to 2020

Source: World Bank, Bloomberg, FactSet 12/31/2019.

Emerging markets debt: Debt in emerging markets remains a risk as they continue to borrow, particularly if the global economy takes longer than expected to recover. However, for the most part, debt burdened countries do not consist of a large part of the equity universe. Countries that have had the greatest issues in recent years, like Turkey and Argentina, are relatively insignificant in the equity world. Also, the world used to be less integrated and, thus, less concerned about emerging-market crises. Whereas now, rescue packages and organized debt restructurings are more prevalent and likely. Contagion is less of a risk.

China’s equity rally has been driven by an unsustainable retail surge: Yes, China has experienced inflows from retail investors, much like the Robinhood phenomenon the U.S. has seen during the pandemic. For China, many are comparing it to 2014 when a retail boom cycle led to a bust in the market. While this is always a risk, there are differences this time that may mitigate the risk. There are more foreign institutional investors, more local institutional investors (active mutual fund issuances are 4 times what they were a year ago), and the government is more aware of the risk. As such, we believe there are more active participants to temper the risk.

Emerging markets has been a bad place to invest compared to the U.S.: On a relative basis, emerging markets has not performed well over the last decade and investors have been waiting for the tide to turn. Historically, regional leadership has worked in cycles. In the early part of the century, emerging markets prevailed, though, since the financial crisis, the U.S. has outperformed emerging markets. Despite this relative underperformance over the last 10 years, emerging markets has still created value for investors. While volatility is generally higher, investors have seen return for that additional risk.

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The opinions expressed in this article are those of Ivy Investment Management Company and are not meant to predict or project the future performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: Investment return and principal value will fluctuate and it is possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Investments in countries with emerging economies or securities markets may carry greater risk than investments in more developed countries. Political and economic structures in many such countries may be undergoing significant evolution and rapid development, and such countries may lack the social, political and economic stability characteristic of more developed countries.

The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.