Why We are (Cautiously) Optimistic on Emerging Market Equities
The year of 2022 proved to be one of the most challenging and volatile for emerging market (EM) equities. By the middle of 2022, it had become clear that a combination of rising inflation, slowing demand amid rising interest rates, and heightened geopolitical risks were key adversaries dominating the thoughts of investors worldwide. As we crossed into 2023, markets have remained volatile, and very top-down driven, with a focus on factors around inflation, central bank policy, the war in Ukraine, and tense US-China relations. However, as markets become more driven by fundamentals, we believe stockpickers’ patience may be rewarded.
During the last year’s perfect market storm, investors faced a confluence of macroeconomic and EM-specific factors impacting their returns. There were big changes being priced in by the markets as the curtain went down on the environment of low interest rates, high valuations, growth outperformance and the all-important central bank action. 2022 heralded a dramatically different market environment with rising interest rates, high inflation, the war in Ukraine, outperformance of value stocks, slowing economic growth and the multitude of negative factors bringing about the correction of Chinese stocks.
Amid an overall risk off environment, the US Dollar strengthened, weighing on equity valuations across emerging markets and resulting in the worst year for the asset class since the Global Financial Crisis[1].
In the meantime, as China faced a barrage of negative factors, only a few emerging economies showed some resilience to external pressures. Such as Mexico and India for example, both mainly defensive and domestic demand-oriented economies, which have also recently benefitted from supply chain diversification efforts. Other more resilient economies were helped by higher commodity prices, such as Indonesia in ASEAN, Brazil and South Africa.
Don’t forget the global pressures
We think that emerging markets today are in a much better shape than last year. Their appeal to investors is supported by attractive valuations, particularly when compared to their developed market peers. After several years of relative underperformance[2], we believe the improving outlook for emerging markets is fuelled by several key drivers. One is the pace and scope of China’s economic recovery which followed the cessation of the government’s strict Zero COVID policy. Good economic news from China, and from India, could meaningfully widen emerging markets’ growth differential relative to developed markets for 2023.
Another positive factor is the easing inflationary pressures for most emerging markets, while the slowdown in demand for the tech and semiconductor end markets in the US seem to be less significant than feared. This could support outlook for the export-oriented markets like South Korea and Taiwan, in the absence of a recession in the US.
There are other supportive trends like supply chain diversification and nearshoring, that may benefit India and Mexico for instance, while Thailand could be the key beneficiary of an influx of tourists following a full reopening of China after COVID.
That said, a word of warning: investors will need to follow closely the difficult US-China relations, particularly around Beijing’s attitude towards Taiwan. It is also paramount to have more clarity on the direction of inflation in the US, and consequently the US Dollar, as we seem not to be out of the woods just yet. Monetary signals point to a reduction in excess liquidity in the coming months. More recently, the re-pricing of the yield curve on US data has delayed the end of the tightening cycle, pushing the US dollar higher and consequently Asia and emerging market equities lower. Lastly, a weaker US Dollar is a prerequisite for a sustained rally in emerging market equities.
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[1] Stock and bond markets shed more than $30tn in ‘brutal’ 2022
[2] Why the outlook for emerging markets is improving after years of underperformance