Buying Emerging Markets is a Consensus Trade for 2021, But Can it go Wrong?

As December chimes in with its festivities and feel-good euphoria combined with a nostalgic melancholy of a good or bad or a so-and-so year, the general ambience is fairly gleeful and optimistic on the hopes that finally, there is a cure available for Covid-19, the most impactful event of the current year. And the Market isn’t different either. For economists, stock market participants, investment researchers and portfolio managers, December usually is that time of the year when the hot commonly discussed and debated theme becomes: ‘Forecast For The Next Year’. The critics may argue that this activity of foretelling the upcoming year’s market is more like ‘Crystal ball gazing’ and only has a moderate rate of success. But that certainly has not deterred market specialists from writing thematic reports on ‘Investment Outlook for the Next Year’ and this year too, reports with headlines such as ‘Top Picks for 2021’ or ‘The Best Performing Markets for 2021’ or ‘2021:Where your Money should be?’ are being published with a fair regularity. 

Considering how exceptional and unexpected the year 2020 has been with the huge impact that Covid-19 has had on people’s lives and the global economy, it is within reason to expect that the ‘Recency Effect’ will indeed play a role in most of the market specialists’ forecasts that contemplate how the prices will behave for commodities like Crude Oil in 2021. It is also important to note that the year 2020 has not been bad for Emerging Markets (EMs) as a basket but markets like United States are still marginally ahead. But even if we discount these factors, it is interesting to see that most Investment Research Houses and Global Fund Managers expect Emerging Markets to outperform in 2021. 

Most of these Global Asset Managers believe that the Emerging Markets (EMs) will be the best asset class in 2021. The reasons are simple: Recovery in economic growth and change in investor sentiments, as vaccine for Covid-19 becomes available and gets widely distributed. But there are other factors that require consideration and they need to be tracked consistently to see if the core assumptions behind the EM story continues to remain valid. The global economic and financial system is a complex machine and the forecasts could go wrong with the slightest of changes in the levers of this system. And this is not to put the market forecasters at fault but just the way how the future sometime plays out.

Despite a high degree of optimism, there are reasons why EMs may still not have a great 2021. One reason being the assumption of the US dollar’s weakness, which most portfolio managers believe will be good for the global economic growth and determine how the EMs would perform next year. Since the COVID related market crash in March of this year, EM currencies as a whole have fared well against the US dollar. But that is more because of how the monetary policy adopted by the US Fed has played out. The Fed may not pause when the monetary policy intervention is needed but if the economic growth outlook gets better in the US, there may not come a need for that. And if this becomes the case, then there is no certainty that the US dollar will continue its weakness. 

There is another reason why the US dollar could behave differently even when nothing changes in the US economy or the Fed’s near-term policy. From the perspective of the EMs, the US dollar has fallen significantly after the US Federal Reserve slashed interest rates to record lows in its response to the Covid-19 pandemic. But the global risk sentiment is a big driver for assets like Gold and the US dollar. And this reflects in the dollar which is known to have big swings, without any underlying fundamental reasons, anytime there is a change in risk sentiment. As of now ‘Add Risk’ trade is the flavour, but any reversal in this risk sentiment could change the outlook for the EMs.

The Covid-19 vaccine roll-out and its success in returning life to normalcy is a big factor in the preference of EMs among fund managers. The broader expectation is that the impact on the economy from the vaccine deployment will be positive. However, the implementation of vaccination programs and the logistics involved will definitely be a huge challenge for many countries. Even though the ‘base case’ pertains to having no doubts regarding the efficacy of the corona virus vaccine, there still are challenges like: a) the huge population of many EMs that ensures that it will take a while before the vulnerable groups get protected, and, b) there are a number of surveys which reflect a general reluctance in giving a positive nod to the vaccine by a significant proportion of the population, indicating that the vaccine will take some time before gaining acceptance .

And then there is this habit of throwing a wrench at the investors which the EMs have done in the past. Some of these issues are related to structural deficiencies, lack of ‘Best-in-Class’ systems and political changes. These events could lead to investment thesis going awry and although it is probable that these events could play out in any geography, they are more common in the EMs. In most of the circumstances, the information discovery in the EMs is difficult for investors to attain, particularly for the investors from developed markets, and it is usually too late before they can react. This could be because of language barrier, lack of data and challenges with timely dissemination of information. 

The information discovery challenge is huge and while it might take years if not decades before many of the EMs reach the same level as developed markets, EMAlpha is making its contribution in tackling this issue. EMAlpha has solutions for Multilingual Data Collection and Real Time Targeted Information which are based on proprietary processes to collect relevant data across multiple markets. The coverage expands across Emerging Market equity, currencies and commodities and the work has also been very successful in testing the signals in some of the key markets for live trading strategies.

With development in AI and technology in areas like NLP, there are considerable new possibilities to bridge the gap in information between emerging markets and the more developed markets. This implies that the evolution in the field will only accelerate as time goes on. While the forecasts on how emerging markets will fare in 2021 could still go wrong, there is now much more hope and optimism that with the usage of technology, things like information discovery and data availability on EMs for investors will certainly get better.