US 2020 Election Investment Pulse: Resilience and Vulnerability in Emerging Markets

Transcript

Stephen Dover: Welcome, Andrew.

Andrew Ness: Thank you, Stephen.

Stephen Dover: Andrew, how has this election in the United States broadly affected, or how do you think it will affect, the emerging markets?

Andrew Ness: We don’t as a team spend a huge amount of time predicting political outcomes. The bulk of the active risk is very much at the individual company level. I rarely see these top-down factors like politics as a source of risk. That said, we do need to be aware of what those risks are. So, the topic is very relevant to us. We’ve been fascinated watching the US election. I think there are three high-level reasons to be positive for emerging markets if we have the anticipated—and it’s yet to be confirmed—combination of a Biden presidency and a Republican Senate. First of all, you could expect a softer policy stance towards China. I think we should certainly expect reduced trade uncertainty and I think less disruptive foreign policy. I think these are the key market expectations that should be seen as positive for global markets and specifically for emerging markets. I think in terms of Biden himself, [he] is very much seen as an establishment globalist, which means that his election would signal a US return potentially to the Paris accord, to the Transpacific Partnership and possibly even the Obama Iranian deal. So, it would be a potential positive bump from multinationals and governmental organizations like NATO [North Atlantic Treaty Organization], the EU [European Union], the WHO [World Health Organization], the WTO [World Trade Organization].

Stephen Dover: So, whenever the United States enters these transnational organizations, that’s generally a positive for the emerging markets. Let’s do a setup in terms of how you think about emerging markets. I know people ask about growth versus value, and you and I were talking about really how you look at it in terms of the rotation from resilience versus vulnerability. Can you explain that kind of basic philosophy you have as you look at emerging markets?

Andrew Ness: Yeah. I think that the growth versus value conversation is that our industry desperately tries to revisit time and time again, but from our perspective, the boat’s changing. And I think we need to look perhaps more at countries and companies with vulnerabilities and countries and companies with resilience. And I think you need to look in the short term versus a long term. If you look in the very short term, I don’t think any of us would be surprised if traditional value outperforms. I think we saw a great deal of evidence of that in last week’s very sharp style rotation. I just read a very interesting comment in the FT [Financial Times] that made me laugh. Rather than thinking of this as a “black swan” event—it clearly isn’t—think of it as a gray rhino. A gray rhino is a large, obvious event. It’s easily ignored until it suddenly charges. So, I think you could see an environment where these unloved, under-owned names do well in the short to medium term. But longer term, and certainly from our perspective, looking at emerging markets, we see continued digital disruption of a range of industries. I think that that creates a disruption threat that persists, and I think many business models and the more traditional parts of the market, whether it’s in energy or financials or retail, I think these businesses are facing uncertain futures. So that’s why we talk about this resilience versus vulnerability. And we focus on businesses that are typically more resilient to economic disruption. And they’re typically resilient to the digital transformation that we’re seeing taking place right now.

Stephen Dover: Well, I think that’s something that maybe many people aren’t aware of about emerging markets, how dramatically they’ve changed. And to that extent, the benchmarks have changed over the last five, 10 years. They’re not as dominated by energy and materials and exports as they were. They’re heavily weighted now in technology. And that’s changed how you look at investing in emerging markets as well.

Andrew Ness: Yeah. I started in my career in late ‘94. The market watchers and historians amongst you will remember that was a very volatile period for the asset class. It was a deeply commoditized and cyclical asset class. We had a substantial number of countries that were dominated by commodities, typically dominated their indices back then. And then over the last two and a half decades, as you clearly outline, we’ve seen a remarkable transformation. Our countries now give us exposure to some leading-edge technology and innovation. That’s very much reshaping the industrial landscape across a range of emerging markets. And we still think that there’s a misperception about what the emerging market class has to offer because of that change.

Stephen Dover: So, the white rhino in the room, if you will, is this the COVID and the pandemic. And of course, we’ve gotten some fairly good news about vaccines that might come out. With emerging markets, of course, the issue is how quickly might the vaccines come out? One of the things President Biden might do is rejoin the World Health Organization, which would have some impact on how vaccines are distributed. So just broadly, can you talk about how the pandemic has affected emerging markets and how you see the vaccinations rolling out?

Andrew Ness: Yeah, sure. Going back to my comments about my start of my career—the type of crises we’ve had to deal with in the past were very much traditional emerging market balance of payment crises with overvalued currencies, too much foreign borrowing and an implosion and the external accounts. I think this crisis was very different in its nature. It was global, across all countries at the same time. And we saw a range of countries being able to deal with that. I think North Asia has proved itself to be highly effective in terms of the strength of its institutions and its corporates, the behavior of its individuals, they seem to have been able to manage the crisis reasonably effectively. Other parts of the asset class, where they’ve got less fiscal flexibility and the health care outcomes have been much worse, have clearly been much more badly impacted.

Looking forward, we’ve been reasonably conservative in our expectations of the recovery: our assumptions have been that it wouldn’t be until Q4 [fourth quarter] next year. So, Q4 2021 that we start to see more normal economic activity across most of our economies. Now, we’re actually hoping with the news from the vaccine developers these last two weeks that that’s too conservative. But my personal take is I think we’re going to be much more active, economically much earlier next year, as a consequence of two things. One, I think we’ll get the rollouts of the vaccines started, but two, I think there is a potential that we see the pandemic moving from being defined as a pandemic to perhaps being more seen as an endemic respiratory illness. I’m sitting here in the UK where we’re in a partial second lockdown, but the reality is our health care systems are coping reasonably well. And it doesn’t appear to be the significant pickup in infections that we were perhaps fearing six or eight weeks ago. I’d like to think that we can view that across the rest of our emerging market asset class, where it doesn’t seem to be that we’re seeing another round of lockdowns. So, the economic consequences of a pickup in infections may not be nearly as severe as they were during that first major period of lockdown.

Stephen Dover: My experience with emerging markets is that because there’s been so many different crises (if you will) over a period of time, that the countries and the companies are very well equipped to deal with crisis. And your point, I think is important, that you think that there might be a recovery earlier than many others predict within many of these emerging markets. So, with that, let’s go around the world and talk about the various and very diversified emerging markets. Of course, let’s start with China and look at your outlook for China and particularly the Chinese companies and sectors.

Andrew Ness: I think China, I think we can’t ignore that the political consequences of the Biden election, assuming that it’s confirmed, I think China is the big one from a political perspective where we could see a positive outcome being a comprehensive review of US policy towards China. And I think the markets would welcome that wholeheartedly. We would then expect the two sides to perhaps engage more actively than they have done until now. Next year could be a period of reproachment with potentially moving to new trade accords at the end of next year or into early 2022. And that would certainly be a much more positive outcome than perhaps we were thinking six months ago. There is a big risk for Chinese assets, however, in the markets there—and we’ve seen evidence of this in recent weeks, unfortunately—that before the new administration takes control, I think the current US administration may be looking to implement additional measures against China. I think some of those could be difficult politically to unwind. And I think that could bring short-term volatility and associated currency volatility to markets. So, it could be a couple of noisy months, unfortunately for China-watchers ahead.

Stephen Dover: China in the last two or three weeks just rolled out its 14th five-year plan; that’s the economic plan and what they plan to do. It was notable that China is really trying to make itself self-sufficient. It’s really not trying to be as dependent on exports, more consumer, having its own technology. How do you see that changing the market and where China’s probably going to go in the next five years or so?

Andrew Ness: It’s a key area for discussion. I think this whole notion of de-globalization and supply chains being brought back onshore, etc., has been clearly spurred by the policy developments that we’ve seen over the last 12 months. China at some point was always going to shift its economic model from a CapEx- [capital expenditure] dependent one towards much more domestic consumption, and we’re clearly in the midst of that. And we do anticipate that the next five-year plan will look at further evidence of how that’s going to be rolled out by the administration.

We think that the Chinese consumer opportunity is still one of the most attractive, most exciting investment opportunities for investors today. I think there are two aspects to that. There’s one, the continued under-penetration across an exciting range of various goods and services, that traditional penetration story that’s very resonant across the larger markets, but two, we know Chinese consumers, to a large extent, have already emerged. We’ve got a very large consuming middle class already. And these consumers are no different from us, Stephen, whereas they have gathered more wealth and income over recent years, they like to spend their money on better things, better experiences, better products, better services. So, there’s a premiumization opportunity in the heart of that consumption story, but then China.

Stephen Dover: So in the previous five-year plan, part of that plan was what was called the “Belt and Road” where China was really trying to develop a lot of other emerging markets, either through the sea lanes or through roads and development. What do you see as the future of China’s relationship with other emerging markets and how dependent do you think those emerging markets are going to be on China in the future versus their relationship with the West?

Andrew Ness: Again, a key question. I think if you look at Belt and Road, you’ve got to put the context of the evolution of China’s foreign policy. And if you look at the trade war and the strategic rivalry between China and the US, we’ve always viewed that as part of a war of political hegemony between the two superpowers. And that’s being played out, whether it’s in the South China seas, as we know there’s been ongoing tensions, whether it’s been played out in the Middle East or Central Asia via the One Belt One Road problem, I think China’s foreign policy for years was from the Deng Xiaoping up until Xi [Jingping] was very much a case of keeping a low profile, and a low profile on the international stage. And then since, you know, Xi’s inheritance of power there, I think China’s now moved to a different dynamic where I think China is very keen to demonstrate to the world just how far they’ve come. And you’ve got evidence of that through the 2025 vision, the “Made in China” vision. And I think that’s ultimately responded a new US policy trying to figure out a way to rein in China’s emergence. So, we’ve had this trade dispute that moves into something perhaps more strategic. I think many countries across the globe will be having to consider if the world is going to split into this bipolar, one world, two-systems structures, which do you want it to be with? That’s not an easy question, particularly for those countries that are trained to do their best to sit in the middle, perhaps like the UK.

Stephen Dover: Well, that’s interesting. And we can talk about China this entire time, but one of the things about emerging markets is how diversified there are and how many countries and, and one country we don’t hear so much about, is [South] Korea. So maybe just briefly talk about your outlook on Korea.

Andrew Ness: I touched on this earlier in my comments that when we looked at North Asia, so China, Taiwan, and [South] Korea, and how all those countries have typically handled the pandemic fairly effectively. And I think it’s a testament to the quality and the strength of their institutions, the governance and the health care structures. But also the point you made earlier that these countries have been through similar crises before, and have learned lessons from the past. When we look at Korea, we think there’s a huge opportunity for investors there and a number of very exciting companies. But that’s also complimented by that the top thing opportunity that we see in Korea. And again, people don’t typically talk about these things that much.

If we look at Korean balance sheets, for example, at a sovereign level, Korea is one of the least-leveraged major countries we can find globally. I think government debt to GDP [gross domestic product] is less than 45%. I think here in the UK, we will be reaching 100% this year with our fiscal stimuli. The country is very much at the leadership of the tech industry. So, for companies that are benefiting from lockdowns and benefiting from those disruptive trends, I think Korea is well-represented there. The country is a net oil importer and oil prices having collapsed with the collapse of economic activity, clearly a benefit to a majority of emerging markets actually like Korea that are net importers. And many emerging markets unfortunately, are suffering from the collapse of international travel and tourism. I don’t think you’ll find that many families going off to Seoul for holidays, although it’s one of my favorite cities to visit. And again, there’s a resilience to that top-down picture from these factors.

One final point—and, again, it’s a surprise to many—that for a long time, corporate governance in emerging markets has very much been seen as a headwind for investors, given some concerns and inappropriate practices. We’re now seeing that becoming increasingly a tailwind in countries like Korea, which are actually at the vanguard of that, where we’re seeing through government prodding, but also investor engagement, a much improved corporate governance environment, and much better alignment between listed companies and investors than any time I’ve seen in my investing career.

Stephen Dover: One of the things that we have heard a lot about is changes in the supply chain out of China as the West tries to diversify. Some of that might be pulled back into the United States or the West, but perhaps also a move to Southeast Asia. So how do you see Southeast Asia, particularly with the supply chain or what opportunities do you see there?

Andrew Ness: Yeah, I think that’s a process that had been going on for some time prior to COVID. I think most multinational companies with manufacturing facilities were looking for a China plus one, or China plus two policy. And that clearly was benefiting countries like Thailand, countries like Vietnam, that had the capacity to absorb some of those manufacturing relocations. What we’ve seen with COVID is clearly a response of global multinationals rethinking their supply chains. I think that favors, to some extent, a number of these ASEAN [Association of Southeast Asian Nations] countries; however, you need to be aware that there’s a scale issue here. Vietnam in terms of its capacity to absorb additional manufacturing activity from China is going to be ultimately constrained. China has the benefit of huge operating scale, vast tracks of land and established infrastructure. So, I don’t think we’re going to see a significant chunk of manufacturing relocate, but certainly at the margin, these countries are well-positioned to benefit from that that continued offshoring from the mainland.

Stephen Dover: Of course, if we look at a country with scale and size and population, we have to look at India. What’s your outlook for India at this point?

Andrew Ness: India is a fascinating market for investors. There are so many opportunities. I mentioned the consumer opportunity in China—equally, India has a very large population under-developed in many parts of its consumer economy. And we can find—as I mentioned with China—opportunities, both from a penetration perspective, but also that premiumization story where again, we’ve got a growing, large, consuming middle class in India that wants to experience better things and buy better products. So, I think there’s always going to be opportunities for us. The economy unfortunately, was in a cyclical low as the pandemic struck, so it compounded much of that economic pain. India’s policy was to instigate a pretty severe lockdown, one of the strictest we saw enacted across emerging markets, and that’s led to a very difficult economic environment. But, as with all other countries, COVID will pass and there will be recovery. And I think we should expect long-term opportunities to remain intact in India.

Stephen Dover: Let’s make a big leap around the world and go to Brazil. The president there, Bolsonaro, was one of Trump’s closest allies. So, having a Biden presidency is probably not positive for him. What do you think about Brazil?

Andrew Ness: I think you hit the nail on the head. With this election of the Democrats and the Biden administration, some people would argue that de-legitimizes right-wing populism and ultimately undermines Bolsonaro’s ideology that could in theory start to hurt trade relations between Washington and Brasilia. You look at Bolsonaro, he’s becoming increasingly isolated within the Americas, given the shift to the left side of the political spectrum that we’ve seen both in North and South America over recent years. And also, a Biden administration may not necessarily be great for oil, gas and commodities, which would be seen as potentially harmful for Brazil. But this goes back to resilience, Brazil is a country that’s had a lot thrown at it over the last two or three decades. It’s been a pretty volatile place, but they’ve got remarkable resilience, both as people and as an economy. And we still think that the reform process that the administration is adhering to, they’re desperately keen to get the fiscal sustainability onto an even keel. We’re operating in an environment where Brazilians are enjoying historic low inflation and interest rates that we’ve never seen before in economic history and there’s huge potential if we can stabilize the fiscal dynamics and we get the recovery out of COVID over the next six to 12 months. Then, I think Brazil could be a really interesting place for investors to look at over the next 12 to 18 months.

Stephen Dover: Let’s look at Mexico, which is at the opposite end of the political spectrum. Of course, what happens in America is very important to Mexico.

Andrew Ness: In terms of Mexico, it’s been reasonably quiet. I think all eyes have been focused on Brazil and indeed other parts of Latin America. I think it’s been a difficult political transition for the country. AMLO [Andrés Manuel López Obrador] has a very clear set of principles of how he wants to lead the country, and his economic approach is less than orthodox let’s say. I mentioned my career starting in ‘94. So, within three months of starting, I encountered the Mexican peso crisis, which was a substantial devaluation of the currency and a really severe economic and social crisis that even now looking at credit penetration and other development signs in Mexico, the country still struggled to fully recover 25 years later. So, I think Mexico has challenges in the short term which certainly weren’t helped by the Trump administration. Hopefully, we get renewed and improved relationships across the border. And I think some of those longer-term opportunities in Mexico will be coming. You know, it’s something that investors can focus on again.

Stephen Dover: Let’s turn to Russia, obviously very involved politically in different ways with the United States. What is your view on the Russian market?

Andrew Ness: We like the Russian market. And again, our opinion is always informed by the quality of bottom-up opportunity that we can find. I think from a top-down perspective, Russia is fascinating. We’ve had the sanctions resume, and clearly, that’s not been ideal. But in some perverse way, sanctions have ultimately made Russia more investible in the sense that they afford a great deal more self-sufficiency and self-reliance in the country. They’ve had to improve their domestic efficiency levels, they’ve paid down a substantial amount of external debt. They’re one of the least leveraged countries globally; government debt to GDP is even less than in [South] Korea. Households are typically under leveraged.

So, there’s a huge amount of resilience to the Russian economy, but clearly there needs to be because of its heightened sensitivity to oil prices. But even if we look at the oil side of the economy, they’ve been saving excess oil income for a rainy day and they’re able to use those sovereign wealth funds in periods of lower prices. The oil companies themselves have highly resilient business models. Some of the companies can be a cashflow positive even at US$15 [per barrel] oil. So, there’s an inherent resilience to Russia that I think people underestimate. One of my personal sort of political ideas had been that the Americans’ typical approach with Russia is that they would seek to sort of forget some of the awkwardness and ugliness of recent years. I think there’s a lot more common interests between the two countries than people realize, and I didn’t feel that America had the capacity to have two strategic rivalries ongoing at the same time with both China and Russia. Now, I think Trump would probably have liked that outcome, but unfortunately, as we’re all aware, the Russian investigation basically blew it out of the water. Where Biden administration takes its Washington relationships is for me, a really interesting thing to monitor and watch. I don’t think he’ll be in a rush to do anything too soon. I think within the next six months to 12 months, we should get an understanding of how that relationship is going to evolve.

Stephen Dover: Thanks, Andrew. It’s hard to cover all of these markets in a short period of time. Just very briefly, can you say where are you see the biggest two or three opportunities right now in emerging markets?

Andrew Ness: I think that [South] Korean opportunities, given the valuations we see in the country, to us are very exciting. And that’s particularly in some of the leading technology names there. I think in emerging markets, the e-commerce opportunity remains appealing, and that’s across a range of countries—in Taiwan and China and Russia and Korea and Latin America. And then I think Brazil is a market where the country and the people have had a very tough time. I really hope they’ve got the resilience and the stability to get through this. And if they do, I think there’s a tremendous opportunity given the country’s demographic profile and its abundance of natural resources and agricultural goods. There’s a lot going for Brazil hopefully in coming years.

Stephen: Great. Well, thank you, Andrew. This has been a really fascinating conversation. I appreciate talking with you.

Andrew: Thank you.

Host: And thank you for listening to this episode of Talking Markets with Franklin Templeton. We hope you’ll join us tomorrow for the final episode in our special daily podcast series related to the US elections, when we’ll focus on the fixed income market impact. And, if you’d like to hear more, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about any other major podcast provider.

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