Five things to know about Chinese and emerging market stocks

May 21st, 2020 | By | Category: Equities

By Talley Léger, Investment Strategist in the Global Thought Leadership team at Invesco.

Talley Léger, Investment Strategist in the Global Thought Leadership team at Invesco.

Talley Léger, Investment Strategist in the Global Thought Leadership team at Invesco.

As the world remains in the grip of the coronavirus, we’ve received many questions about the outlook for Chinese and emerging market (EM) stocks—as China was ground zero for the pandemic. First and foremost, we’re asked what the challenges and opportunities are for that country and region?

Meanwhile, US and developed market (DM) stocks have delivered outperformance for the past decade or more. Will they continue to do so?

In many ways, we’re witnessing the environment change and evolve in real-time. From a market perspective, perhaps the twin external shocks from the coronavirus and plummeting oil prices may prove to be the catalysts for shifting leadership among regions and countries.

In our view, the outlook for Chinese and EM stocks may be better than many investors believe because of a combination of factors: 1) China’s ironclad response to the coronavirus and a flat case count; 2) a re-opened economy and rebounding business activity; 3) cheaper valuations; 4) unprecedented US Federal Reserve (Fed) support and a bearish technical setup for the US dollar; and 5) the relative outperformance of Chinese stocks year to date, which we expect may continue. Each of these warrants closer examination.

  1. Coronavirus cases.

China was the first to implement draconian social-distancing controls and mass shutdowns to contain the coronavirus. The result was a relatively symmetrical flattening of the case curve, whereas the US continues to witness growing infection rates.

Figures 1 & 2. China has seemingly “flattened the curve.” The same cannot be said of the US.

Source: Invesco.

  1. Business activity

Such extreme, yet effective, measures in China came at a steep cost—Beijing sacrificed near-term economic growth, which plummeted to its worst levels on record. Presently, however, China’s economic activity is rebounding in a v-shaped fashion, as evidenced by the sharp improvement in its Purchasing Managers Index.

By comparison, growing infection rates in the US likely mean the worst of the economic damage may be yet to come.

Figure 3: Chinese business activity is staging a v-shaped recovery—rebounding sharply from record lows—while US activity is falling off the “COVID cliff” to record lows.

Source: Invesco.

  1. Valuations + catalyst

As one would expect, structural US outperformance inflated developed market valuations relative to the global benchmark, to emerging markets and to history. The rule of thumb is that overpaying for an asset reduces its prospective return over the long haul.

On the flip side, structural EM underperformance—including China—has compressed valuations to deep discounts. We believe compelling opportunities exist for investors in EM stocks at a time when many emerging economies—especially those in Asia outside of Japan—are recovering from the virus-related “sudden stop” in activity.

Leading indicators of business activity across the emerging world—China and South Korea, in particular—have been proving more resilient than those of the developed world, including the US, Europe, and Japan.

Low valuations and improving economic growth could be a powerful combination for unlocking the potential reward embedded in EM stocks.

Figure 4: Not all regions and countries are made equal. For selectivity, consider targeting low valuations and faster growth over high valuations and slower growth both across and within regions.

Source: Invesco.

  1. US dollar

One major challenge for EM is the US dollar (USD) liquidity shortage and associated upward pressure on the currency. However, the Fed—together with a host of other major central banks—is doing its part to boost US dollar-based liquidity and tamp down the greenback. At present, it appears the currency has stopped going up at such a rapid pace.

Looking ahead, we believe the USD is unlikely to remain an obstacle for investors, as the currency faces challenges in the form of ballooning US fiscal and current account deficits, overvaluation and overbought extremes that warn of a structural bear market for the greenback.

In our view, much of the bad news has already been priced in, so investors shouldn’t get too pessimistic on EM shares. History shows that bull markets are born in despair and die in euphoria; we seem to be closer to the former than the latter. Similarly, oversold extremes in the late 1980s and early 2000s were followed by multi-year periods of EM outperformance. If the past is prologue, this may be another one of those episodes.

Figures 5 & 6: A flat to weaker US currency could boost EM stocks relative to their US competitors. Also, EM stocks bottomed in the depths of the last 3 US economic recessions—important chapters of the “recovery playbook.”

Source: Invesco.

  1. Relative performance

How is the thesis playing out? We believe Chinese stocks have outperformed their US counterparts because of cheaper valuations, an ironclad response to the coronavirus, rebounding fundamentals, and unprecedented Fed support.

In our opinion, the key to sustained long-term outperformance remains the USD. While the Fed’s doing its part to slow the currency’s ascent, investors’ appetite for risk may have to firm for the USD to calm down. Perhaps Chinese stocks are already anticipating that outcome.

Figure 7: Chinese stocks are leading the charge, a trend we expect may continue.

Source: Invesco.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)

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