Extracting Growth Alpha in Emerging Markets
Investing in emerging markets companies with strong secular growth can lead to significant alpha generation over time.
The COVID-19 pandemic and resulting lockdowns led to the most severe global economic contraction in decades in the first half of 2020. But as the lockdowns were eased and restrictions were loosened, economic life moved back in the direction of normalcy. The JPMorgan Global Purchasing Manager Indexes (PMIs), a broad measure of business confidence for both the manufacturing and services sectors, dipped below 50 (which signals contraction) in February, bottomed at shockingly low levels in April and then began to recover. Both the manufacturing and services PMIs moved above 50 in July and registered levels of 51.8 and 51.9, respectively, in August, consistent with expansion in both manufacturing and services globally. Measures of economic growth also surged over the summer months, with the major advanced economies expected to post double-digit GDP growth on an annualized basis in Q3.
Nonetheless, there are already signs that the pace of growth is losing momentum. Growth in Q4 will inevitably be slower than in Q3, and major advanced economies will post annual GDP growth numbers for 2020 that are deep in the red. China’s economic recovery has been out of sync with the rest of the world as its economy absorbed the worst of the virus’s blow in February, and its economic recovery began in the second quarter when most other parts of the world were just beginning to lock down. China’s draconian lockdown was highly effective in subduing the virus. As a result, its economy suffered less damage and bounced back sooner. Thus, China’s economy is expected to post positive growth for calendar year 2020 and may have already regained its COVID-related lost output.
It remains highly uncertain when other major economies will regain pre-COVID-19 levels of economic activity. The Federal Reserve revised up its U.S. growth forecast and expects a smaller GDP decline in 2020, projecting the U.S. should fully regain lost output by late 2021. Consensus forecasts also expect a similar recovery trajectory for the U.S., while Europe and Japan are expected to take considerably longer. The path ahead could be bumpy, as the global economy struggles with the pandemic and its residual effects.
The pace of the economic recovery will depend on the answers to several critical questions. How will the pandemic evolve as the northern hemisphere moves toward autumn and flu season and as kids head back to school? How quickly will effective medical breakthroughs emerge on the treatments and vaccine fronts? How quickly will governments and the private sector be able to scale up production of an effective vaccine, distribute it, and inoculate large segments of the population? Will the U.S. presidential election and subsequent governing regime prove disruptive to both the economy and markets? Will there be a reescalation of U.S.-China tensions? Will governments around the world continue providing sufficient fiscal stimulus to support their economies, or will fatigue and complacency set in? More action is needed on that front, and the cost of letting up may be many times greater than the cost of continued support.
The current downturn was triggered by the pandemic, an external shock, rather than the buildup of economic imbalances that precipitated previous downturns. Therefore, the global economy should be better positioned to bounce back more quickly today than in the years after the Global Financial Crisis. Meanwhile, economic data continue to surprise to the upside, and news about the development of a COVID-19 vaccine and treatments continues to be positive.
The Fed also announced in August that it would change its operating framework to a flexible, inflation-targeting framework. This emphasizes that the Fed will target an inflation overshoot during economic recoveries, following inflation shortfalls during downturns. Thus, the Fed is likely to let the U.S. economy run hotter than it would have in the absence of this change and likely would delay tightening policy until the economy and actual inflation have picked up a considerable head of steam. At its September meeting, the Fed indicated that it does not expect inflation to reach its 2% inflation target until 2023, at the earliest, and hence expects interest rates to remain at zero until 2023.
The biggest downside risks appear to be on the geopolitical and/or political fronts. In particular, the U.S. Congress has been unable to agree on another round of fiscal stimulus. This is a concern, as the economy has not felt the full impact of the pandemic because policy stimulus has filled the hole. While some sort of deal may still emerge, should Congress fail to act, the loss of fiscal support would undercut the progress the U.S. economy has made since May. In that case, the economy’s momentum could carry it a bit further, but ultimately the recovery would slow.
Following the U.S. election, there is likely to be increased fiscal spending on health care and infrastructure (in the case of a Biden win) or further tax cuts and additional spending (in the case of Trump’s reelection).
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