POINT OF VIEW

Kunal Sawhney

has triggered the deepTHE COVID-19 PANDEMIC est economic downturn in Canada since World War II. GDP dropped at an annualized rate of 38.7 per cent between April and June of 2020 — the worst on record since 1961. While federal fiscal policies remain supportive to the overall trade and business ecosystem, investor sentiment continues to be fragile, and with good reason.

The Canadian government’s one-to-three-year bond yield curves remain low, plunging from a high of around 1.5 per cent in February of 2020 to just 0.25 per cent in September, 2020. This has been mostly due to subdued inflationary pressures and pandemic-induced economic uncertainty.

The result: Canada is now staring down a state of ‘stagflation’, just as Japan did in its Lost Decade — a sustained period of economic stagnation from 1991 to 2003. After years of boom, the Asian giant’s GDP growth rate averaged 1.2 per cent. In this long era of low returns with zero bond yields, sovereign debt and a range of deflationary pressures, Japanese investors took to investing in opportunities in emerging economies — not just in Asia but other corners of the world.

The bet paid off. Japan continues to be a critical global lender and investor, betting on long-term returns from stakes in a range of assets across geographies. Back home, Japanese government bonds are today a ‘safe haven’ for investors.

Amidst the current equity sell-off across the globe and falling yields in the Canadian market, investors need to do what is necessary to ensure respectable returns. This requires institutional as well as retail investors to diversify their portfolios by leaving the safety of home and putting their money in emerging market assets.

Today’s emerging markets are dynamic and will be able to withstand the long-lasting scars of COVID-19 with public mitigation policies, increasing private sector adaptability and foreign direct investments — making them a great place for Canadian investors to begin parking their funds.

At the outset of the current millennium, the hubbub was around the shift of global economic power from established economies of North America, Western Europe and Japan to emerging economies in South and East Asia. Projections said consumption in emerging markets (‘EMS’) would expand rapidly and account for a significant share of global consumption.

The forecasts were not far from the reality. Today, China and India have emerged as the first and third-largest economies in the world in terms of purchasing power parity (PPP), sandwiching the U.S., according to a 2020 World Bank report. A report from the International Monetary Fund (IMF) showed similar results.

In the coming decades, emerging markets will play a significant role in driving the global economy’s growth engine. By 2030, Asian economies are expected to overtake North America and Europe in terms of growth, with China leading the way. A PWC study projects that by 2050, six of the seven largest global economies will be today’s emerging markets. The list will be led by China, followed by India and Indonesia.

How Emerging Economies Have Fared

Before the COVID-19 virus slipped out of China and became a global pandemic, emerging market economies were affected by macroeconomic issues like waves of protectionism, intermittent trade wars, oil price swings and financial volatility due to rising internal and external debts. But the overall picture remained positive, especially in relation to advanced emerging markets such as China and India.

As the terror of the pandemic spread and restrictions were imposed to curb it, these growing but fragile economies were pushed, almost instantly, into economic contraction, aggravating trade disputes and intensifying protectionism and leading to a significant fall in foreign direct investment inflows.

Following the large-scale monetary injections and fiscal policy support, emerging markets are slowly bouncing back as the capital that fled begins to return. In March of 2020, the Institute of International Finance tracked a massive US$90 billion outflow from EM stocks and bonds. The rebound inflows to EMS started in April and investors brought back US$60 billion till June. Non-resident portfolio inflows to EMS was over US$17 billion in July and August.

Since hitting a low in mid-march, the flagship MSCI Emerging Markets Index has been steadily rising. In fact, it is scripting better performance than Canada’s benchmark index TSX Composite on the Toronto Stock Exchange.

Compared to developed markets, stock markets of emerging economies have recovered quickly amid pandemic conditions. Many of these markets such as China, South Korea and Thailand have already moved beyond the worst of the pandemic and returned to a growth track. Even though these countries enforced strict lockdowns, economic recovery noticeably improved by the end of the second quarter of 2020.

While GDP growth has been uneven across emerging markets, the overall figures are reassuring. The average GDP of emerging markets and developing economies (excluding China) is expected to contract by 3 per cent in 2020, and then by 5.9 per cent in 2021.

According to an IMF projection, Asian economies will contract by 0.8 per cent in 2020 before growing by 7.4 per cent in 2021. China — the only large economy expecting any progress this year — will grow by one per cent in 2020 and then by 8.2 per cent in 2021. In comparison, the Bank of Canada expects Canada’s economy to contract by 7.8 per cent this year before a 5.1 per cent bounce-back in 2021.

Grasping the Opportunities

By 2030, Asian economies are expected to overtake North America and Europe in terms of growth.

Emerging economies are staring at a slew of short-term challenges that range from lack of strong fiscal stimulus to rising cases of COVID-19 and income loss worries. While these countries entered the crisis with a strong fiscal position and were able to slash interest rates aggressively, the fiscal stimuli remained relatively muted as compared to developed markets.

Their asset purchase efforts, too, have not been large enough to cushion the hard fall in economic activity. The risk of high external and public debt also remains. Yet the fallout of the pandemic crisis would have been worse for emerging markets without strong policy support, which created room to avoid stronger economic blows. Exchange rates have been adjusted to a large extent, national buffer reserves have been used cautiously, and monetary policies eased on time. These actions scripted a narrow but strong recovery path. Combined with a weakening U.S. dollar, emerging markets are likely to generate good returns with growth stocks in the long run.

These favourable conditions should encourage investors to not miss out on post-pandemic opportunities in emerging economies. Following the wave of sell offs in the initial days of the pandemic, traders are now focusing on recovery scenarios amid recession, protracted growth and managing risk factors.

Another factor that continues to support the business ecosystem in these testing times are the competitive currencies of emerging economies, which have further dropped in value with the market sell offs.

Disruptions in supply chain are also creating a new opportunity space for emerging markets which are set to benefit as companies shift out of China. In this ongoing reshuffling of global value chains, countries like Vietnam and India are emerging as frontrunners.

Volatility in commodity prices is also impacting the scenario. The oil price crash, which impacted the economies of Russia and Saudi Arabia, has been a boon for India, which imports most of its oil. With a reduced import bill, New Delhi can spend more on stimulus. If oil prices continue to drop, it will improve India’s current account deficit.

Even before the wave of COVID-19 induced sell-offs, equities from emerging markets were relatively cheaper. While risks are country-specific, investing in emerging market assets can yield attractive long-term returns under these new circumstances.

Investment in Different Asset Classes

Canada’s large pension funds, banks and insurance companies have massive pools of investment capital ready for deployment. Over the years, assets managers have been reducing their clients’ exposure to domestic assets and diversifying their portfolios into foreign assets, especially from emerging economies. These investments have been spread across three asset classes.

1. GOVERNMENT SOVEREIGN AND CORPORATE BONDS:

Investors are increasingly reducing their exposure to Canadian bonds and securities. Amid plummeting yields, non-resident investors reduced their holdings in Canadian bonds by CAD$ 16.4 billion in July 2020, as per Statscan data.

Canadian investors too are reducing their holdings in developed markets. In July, domestics investors sold CAD$ 2.4 billion of U.S. Treasury instruments. Meanwhile, emerging market bonds, with their high-yields, have become an essential element of fixed-income portfolios. The spreads between developed and emerging market bonds have also increased.

2. EQUITIES

Canadian investors have been at the forefront of the Indian private equity scene in the last couple of years.

A prominent example is Fairfax Financial Holding’s investment in the National Stock Exchange of India in 2016. The Toronto-based firm acquired a one per cent interest in the stock market for US$27 million through its India wing. In two years, the investment valuation surged to US$58 million. Large-scale foreign funds have also been deployed to the Indian start-up ecosystem.

Latin America is another target region of large Canadian public pension funds. At the end of its quarter ending June 30, 2020, the Canada Pension Plan Investment Board (CPPIB) diverted nearly CAD$64 billion in emerging market public and private equities with a long-term sustainability focus.

Another suitable avenue among investors has been emerging market mutual funds, made up of equity securities of high revenue companies from a particular region. Some of these have been running for more than 20 years and have provided stable returns.

3. REAL ESTATE AND INFRASTRUCTURE

Canadian entities now own some of the largest infrastructure assets in India. Brookfield Asset Management, through its subsidiary Brookfield Infrastructure Partners, invested CAD$3.66 billion in telecom tower assets of leading Indian conglomerate Reliance Industries. It also acquired RMZ Corp’s income-generating commercial property worth over US$2 billion in October, 2020. RMZ, counted among the largest commercial property developers in India, has recently signed leasing deals with Walmart and Accenture.

Canadian pension funds including the Ontario Teachers’ Pension Plan (OTPP) and Canada Pension Plan and Investment Board (CPPIB) have diversified their portfolios with India’s first sovereign wealth fund, the National Investment and Infrastructure Fund (NIIF). Data shared by the NIIF shows CPPIB Credit Investments Inc investment of US$225 million to the India Resurgence Fund platform,

a distressed assets buyout platform. The OTPP is also in talks with leading Indian realty developer Prestige Group, before the later heads for its REIT listing in local stock exchange.

Looking Ahead

Investing in emerging markets may be afflicted with shortterm pains amid pandemic circumstances and tighter mobility restrictions. But the long-term gain stands out as valuations become more attractive. To independently assess investment grade assets, investors should look at standardized ratings from third-party providers such as Fitch, Moody’s and Standard & Poor, to check upon listed entities.

Of course, there are risks associated with emerging markets. It is a fact that they can be more exposed to political and economic jolts, currency risk, liquidity risk and general market risk. The COVID-19 crisis has made this more apparent by making emerging economies far sicker than developed economies due to lack of adequate fiscal support for welfare and hardly any cushion against unemployment, decimating spending.

Despite high government yields, currency risk has often been cited as a reason not to invest in emerging markets. And while the ease of doing business in developing economies are fast catching up with developed nations, the gap persists. These countries are also afflicted by corruption and red tape.

Despite these risks, engines of emerging market growth have started humming, fuelled by the return of consumer demand as they adapt to the new normal.

As domestic growth slows and yields within Canada remain low, investors must venture out. As indicated, investing in emerging markets became Japan’s trump card to exit its state of stasis, a tactic that continues to ensure returns for the aging nation. Canada, too, must learn to export investments for long-term capital appreciation.