China’s central bank unexpectedly cut borrowing costs in January amid signs of slowing economic growth. Anthony Okolie speaks with Christian Medeiros, Portfolio Manager, TD Asset Management, about what impact China’s looser monetary policy could have on emerging market technology stocks.
- Christian, North American tech stocks have been under pressure since the start of this year. We've seen a rise in US Treasury rates, aggressive central bank monetary policy, as well as expectations that interest rates are going to be hiked this year to tame inflation. What's been the experience from an emerging markets technology perspective?
- Great question, Anthony. We're seeing very much the same story and same picture within emerging market technology companies, specifically software companies with high growth and low profitability. And there's three reasons for this.
The first reason is that a lot of these companies did fantastically well over the pandemic, pulling forward a lot of demand in their key themes such as e-commerce, payments, gaming, food delivery. But given that they are now a victim of their own success because they're now facing high comps from prior years and having to face reopening. And so a lot of investors are concerned that their earnings will not be as attractive this year.
The second issue is that a lot of them are high growth, currently unprofitable, and so a lot of their earnings for investors are going to be farther out in the future. A lot of their value is based on their terminal value. And so when we see higher interest rates, that means that those future cash flows are discounting more and so their value declines.
And then the last reason is that emerging market index as a whole has more value stocks than most other indexes in the world. And we've seen that high inflation, higher interest rates, and strong commodity pricing has resulted in a shift towards value and away from growth. And this is also apparent in emerging markets as managers want to sell their growth winners and buy into the value trade which is working right now.
- OK, I want to talk a little bit about interest rate policy, because we've seen sort of two different sides of it. In China, unlike the rest of the world, China is actually tightening its stance last year in response to curbing the excess of the property market there. What impact has this had on Chinese stocks and other emerging market economies?
- Yeah, that had a major impact both on China and emerging market stocks last year. We saw in China that their tightening stance, their crackdown on the property market, and their very public crackdown on technology shares, really dampened returns in Chinese equities. Particularly among technology stocks, as well as foreign listed Chinese stocks. And so we saw strong negative double digit returns in Chinese equities last year. And because it's such a large weighting in the emerging markets benchmark, that translated into a negative return for the emerging markets index as a whole, so huge impact.
And the other issue to contend with too is that China is a major trading partner for most emerging market countries. And it's also a major end market for many commodities that they produce. So as a result, it produced a dampening effect on emerging market economies as a whole.
- So can you talk a little bit about some of the markets and sectors that might actually benefit from China's easier monetary policy.
- Yeah, that's a great question. So what we're seeing so far this year is the biggest story in markets is that developed market central banks have found themselves behind the curve and having to get more hawkish to contend with inflation. But in a lot of emerging market economies, they've already been hiking for much of the past year or been in a tightening stance. And even now some of them, such as China, are now starting to ease. And we're seeing them lower their interest rates, lower lending rates to kind of stimulate their economy.
And historically when China eased their economy it's been a major boom for emerging markets, it's been a major boon for global growth as China is a major consumer of a whole host of goods. However, this time around we don't think that China's easing will be as magnified as it was in the past just given that they're still concerned about their property markets, still concerned about inequality, and still need to contend with other domestic issues. But all else equal, an easing China is really positive for commodities and it should be positive for a lot of other emerging market economies that have China as their biggest trading partner.
- As you know, in North America volatility has been a big story to start the year, what's your outlook for emerging market equities as we head into 2022?
- That's a great question. When we look at emerging market countries, we've talked a number of times, Anthony, how you can't look at emerging markets as one monolithic entity, they're all very unique countries with their own unique stories. So if we break it down into a few buckets, I'll give you some thoughts on China, India, commodity sensitive countries, and technology.
So on the China front, we see that China now has very reasonable valuations. We've seen the price of Chinese equities have discounted a lot of the crackdowns that we've seen last year, and we've already noted in this conversation how they're currently easing monetary policy. So as a result, they should all be supportive of Chinese equities this year and we're slowly allocating there again as well. But it's going to be still volatile and rocky, especially given that they need to contend with a zero COVID policy, and a host of other domestic issues.
Moving on to India, India has been an investor darling for the last few years. It's had about 30% positive returns last year. They're a top performing major emerging market country.
However, it's entering the year with high valuations, high earnings expectations. And traditionally the Indian economy, given that it's a major importer of commodities, it's really struggled when oil prices have been high and spiking. So we think that India will be more challenged this year.
When we think about commodity producing emerging markets, this would be countries like Brazil and Russia, we think that there's a lot of support behind them, especially given that their equity indices have huge proportions in oil and gas, mining, and financials. They're really beneficiaries of the value trade. But between those two countries, it's such a tale of two cities, a tale of two countries.
Brazil is one of the top performing markets this year, I think up about 14% where Russia is down in the double digits. And that's just because Brazil has seen improvement in their policy and political picture and been able to benefit from flows into the commodity trade. But Russia's obviously struggling with the Ukraine crisis, as well as the risk of US sanctions. So very different story across emerging market countries, and the investor results have been accordingly.
And then lastly, when we talk about the technology portion of the index, Taiwan and South Korea and their semiconductor industry is a major portion. And we've seen those companies really trade sideways for the last year. But at this point in time, their end markets are still very strong, supply chains are improving, and they're guiding for double digit earnings growth. So there's potential for them to break out of their recent range.
Lastly, on the software and the high growth sector, especially those that are really benefiting from the digitization of the consumer that we find so exciting, we think that this year they're going to need to digest the tough earnings comps that we spoke about, and also contend with the higher interest rates. But once they are able to digest those two factors, we think that the tailwinds behind digitization are still there. I think they have massive runways and we still expect the growth to re-ignite towards the back half of this year.
ANTHONY OKOLIE: Christian, thank you very much for your insights and thank you for joining us.
- Thank you, Anthony.