Equity Insights offers research and perspectives from Putnam’s equity team on market trends and opportunities.
This month’s author: Brian S. Freiwald, CFA, Portfolio Manager
We believe emerging market equities have been unfairly characterized as high beta and too volatile. The asset class outperformed U.S. markets in the first half of 2022 despite a Russian market that overnight became viewed as “uninvestable,” a resurgence in Covid-19-related lockdowns, and the typical EM headwind of a strong U.S. dollar. And we see the potential for outperformance in the second half of 2022 as well as next year, driven by attractive valuations, diverging central bank policies, and inflation beneficiaries such as Saudi Arabia and Indonesia.
Emerging market index 2.0: Higher quality, lower volatilityOver the past decade, the changing composition of the MSCI Emerging Markets Index has resulted in higher profit margins and returns on equity, and more resilient cash flows. Specifically, consumer and technology companies have become the largest sectors in the index, while weightings are smaller for the more volatile energy and materials sectors. Also, regional changes in the index have been important. Asia now dominates the index at 80%, while commodity-based markets such as Brazil and South Africa have shrunk in importance.
Less-volatile sectors have grown in the EM Index
Sector composition of MSCI Emerging Markets Index
Index has lower exposure to commodity-based markets
Geographic composition of MSCI Emerging Markets Index
Near-term volatility has created an attractive entry pointEmerging market price-to-earnings ratios peaked 18 months ago at 16x. Since then, valuations have collapsed to trough levels of just 10.5x. At the same time, the risk/reward profile for EM equities is the most attractive since the height of the pandemic. Performance of EM equities peaked along with China’s equity market top in February 2021. After tumbling 35% over 15 months, EM equities appear to have bottomed. While the rest of the world is hiking interest rates, China’s central bank is easing, and the government has implemented stimulus packages in key industries like autos and infrastructure. Looking to the back half of 2022, the inflation outlook could be a key driver of equity returns. Unlike the U.S., several EM countries are benefiting from rising commodity prices and are witnessing much lower inflation. In the current environment, we believe Saudi Arabia and Indonesia are two potential winners.
Saudi Arabia has more to offer than oilWe are bullish on the outlook for Saudi Arabia and we have added meaningfully to positions in our portfolios this year. Saudi’s currency is linked to the U.S. dollar, and its inflation level is just 2.5%. Its economy is expected to recover strongly, driven by high oil prices and the government’s economic and social reforms. High oil prices are positive for the country’s economy and drive consensus earnings upgrades. With oil prices trading around $100/barrel, the country is expected to have a large current account surplus and its GDP is expected to grow at 7.6% in 2022.
In addition, the government has introduced several social and economic reforms under “Vision 2030” to reduce its dependence on oil and diversify its income streams. Reforms include:
- Mortgage interest subsidies to increase home ownership
- The transition of Saudi citizens to a private health insurance scheme
- Government incentives to increase private and public sector capital expenditures
- Relaxation of social norms that could boost consumer spending (for example, allowing women to drive)
These reforms, along with higher oil prices, provide structural growth tailwinds. Today we see significant opportunity in the consumer, financial, and health care sectors.
We see potential for EM equity outperformance, driven by attractive valuations, diverging central bank policies, and inflation beneficiaries such as Saudi Arabia and Indonesia.
Indonesia may be the next Asian TigerWe are also bullish on Indonesia, which is currently the top overweight region in our portfolio. Indonesian consumers are not being squeezed by inflation, as it remains under control at less than 4%. Also, due to subsidies, consumers are not being squeezed at the pump either, as gas prices are just under $2 per gallon.
Our long-term outlook for Indonesia is also positive, as it is expected to be one of the fastest-growing economies over the next two years. Indonesia has a population of 275 million, the fourth-largest in the world, and it’s young and growing. The working-age population is projected to keep increasing through 2030, which could bring a 60% to 100% increase in Indonesia’s consuming class population. This could be a powerful driver for consumption growth.
Consumer markets are growing in Indonesia
Annual consumer spend, $ billions, 2010 prices
Sources: CSI Indonesia survey 2011; Indonesia’s Central Bureau of Statistics; Canback Global Income Distribution Database; McKinsey Global Growth Model; McKinsey Global Institute analysis.
The country is home to many natural resources that have strong demand from both old and new economy industries. Indonesia is the:
- Largest coal exporter (slightly ahead of Australia)
- Largest producer of palm oil
- Ninth-largest copper producer
Indonesia is also home to the largest reserves of nickel, an important material for electric vehicle batteries. This has prompted many companies, such as Ford, LG Chem, Tesla, and Volkswagen, to secure long-term supply in the country. The recent commodity upcycle has helped Indonesia bolster its foreign exchange reserves and record a current account surplus for the first time in 10 years.
Finally, Joko Widodo has been president of Indonesia since 2014, and is one of the longer-serving leaders in the region. He is well-liked because of his commitment to improve the country’s infrastructure, health care, and education. While not immune to the world’s inflation, Indonesia has managed to keep its own prices in check with multiple strategies such as targeted subsidies for energy costs without interest-rate hikes. This has enabled the economy to continue growing strongly, with loan growth remaining solid and consumer confidence at an all-time high.
Exciting potential amid the headwinds
Despite naysayers and irrespective of the macroeconomic backdrop, we are excited about the tremendous long-term potential in emerging market equities. Today we are finding opportunities to own attractively valued high-quality businesses that, in our view, are effectively navigating macroeconomic headwinds and are positioned to double or triple — or more — in size over the next decade.
This material represents an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon as research or investment advice regarding any strategy or security in particular. Any mention of specific securities is intended to help illustrate Putnam’s research process and should not be considered a recommendation or solicitation to purchase or sell the securities. Potential market trends and opportunities were selected without regard to whether such trends and opportunities, or relevant securities, were profitable and are intended to help illustrate our investment and research process. It should not be assumed that any investment in these securities was, or will prove to be, profitable, or that the investment decisions we make in the future will be profitable or equal to the investment performance of securities referenced herein. There is no assurance that any securities referenced herein are currently held in a Putnam portfolio or that securities sold have not been repurchased. The securities mentioned are not necessarily held by Putnam for all client portfolios.
This material is prepared for use by institutional investors and investment professionals and is provided for limited purposes. This material is a general communication being provided for informational and educational purposes only. It is not designed to be investment advice or a recommendation of any specific investment product, strategy, or decision, and is not intended to suggest taking or refraining from any course of action. The opinions expressed in this material represent the current, good-faith views of the author(s) at the time of publication. The views are provided for informational purposes only and are subject to change. This material does not take into account any investor’s particular investment objectives, strategies, tax status, or investment horizon. Investors should consult a financial advisor for advice suited to their individual financial needs. Putnam Investments cannot guarantee the accuracy or completeness of any statements or data contained in the material. Predictions, opinions, and other information contained in this material are subject to change. Any forward-looking statements speak only as of the date they are made, and Putnam assumes no duty to update them. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties. Actual results could differ materially from those anticipated. Past performance is not a guarantee of future results. As with any investment, there is a potential for profit as well as the possibility of loss.
This material or any portion hereof may not be reprinted, sold, or redistributed in whole or in part without the express written consent of Putnam Investments. The information provided relates to Putnam Investments and its affiliates, which include The Putnam Advisory Company, LLC and Putnam Investments Limited®.