Against a backdrop of inflation, geopolitical tension and slowing growth, 2022 was tough for emerging markets (EMs), with the MSCI Emerging Markets Index falling 10% in sterling terms, while funds in the IA Global Emerging Markets sector lost a collective 12.2%.
Of course, when it comes to EMs, investors accept that the prospect of greater growth versus developed markets comes with the additional risk of greater volatility.
The volatility last year was a continuation of that seen in 2021, when EM investors were rocked by a regulatory crackdown in China that sent returns spiralling. Just as markets were recovering, the region was again in the spotlight as a result of Russia’s invasion of Ukraine.
However, as risk assets rallied, EMs are in better shape at the start of 2023, with the MSCI index up 6.1% year to date and commentators talking up the region’s prospects.
In this month’s head to head, James Johnstone, co-head of the emerging and frontier markets team at Redwheel, looks at the factors that will drive performance in EMs in 2023 and beyond, while Anu Narula, head of equities at Mirabaud Asset Management, gives his outlook for the sector.
Anu Narula
Head of equities, Mirabaud Asset Management
EM equity investors have not had much to shout about for the past couple of years. This follows on from what has been described by some as a ‘lost decade’ for the asset class relative to US equities.
However, things are now improving, and we believe we are entering a 12- to 24-month recovery in EM equities, predicated on a number of cyclical and structural drivers.
The first cyclical catalyst is China’s reopening, the significance of which is hard to overstate for EM equities. The restrictions during 2022 had a hugely negative impact on supply chains, employment and sentiment. As activity normalises with the relaxation of restrictions, at the same time as the regulation of property and platform company sectors eases, this should provide significant support for China equities and EM more broadly.
The next catalyst is slower US growth. This growth, and the resulting US equity market strength, has been a critical factor in the EM ‘lost decade’. In terms of investment flows, when the US is doing well, global investors tend to gravitate towards it. It is also the ‘safe-haven’ market investors retreat to when global growth retrenches significantly. What EM equities need to outperform is a period of US growth not too far above or below the long-term average, which is what we expect to begin in Q1 and continue for about 12 months.
Slower growth in the US and developed markets needs to take place at the same time as GDP growth in EM picks up. We expect this to occur this year, driven in large part by China’s reopening. This higher GDP growth should then translate into stronger earnings growth for EM corporates, making them more attractive than developed market (DM) counterparts.
Consensus estimates point to EM earnings outpacing DMs through 2023 and 2024. Importantly, the consensus is arguably still too optimistic for the US, whereas expectations for EMs have experienced a protracted down-cycle in which companies are now beating these lowered expectations.
Reversing the negatives
We are also seeing a peak in the pace of Fed tightening. Higher US interest rates, and correspondingly higher US treasury yields, have been a significant headwind for key EM sectors such as technology, as well as for our Garp investment style. They have also fed into dollar strength. As the pace of tightening slows, these negatives should reverse, providing a more supportive backdrop for EM equities.
In addition, the strength of the dollar, which until recently was at a 20-year high, has been a notable headwind for EMs and equities during 2022. When this trend reverses, it should provide a significant tailwind.
As for valuations, EMs are unarguably cheap, as they have been for some time. However, the relative valuation argument versus DMs is perhaps more compelling. With many EM stocks trading at distressed levels, this provides an attractive risk/reward proposition.
The final cyclical catalyst is investor capitulation. Widely watched as a way of timing inflection points in asset classes, this was largely satisfied in 2022, as outflows matched or came close to historical peaks.
On top of these cyclical factors, EMs are also benefiting from multiple longer-term structural drivers, including India’s continued development and urbanisation, and the continuation of EM financial inclusion – which is one of our key themes. We also see further productivity growth and a global investment cycle based on the ongoing reshoring of production to defend against future supply chain disruption.
At this stage, we do not suggest these structural factors are enough to propel EMs into another multi-year supercycle, rather they provide extra support for the asset class’s long-term growth outlook. Married with the cyclical catalysts, these provide an exciting backdrop for the remainder of 2023.
James Johnstone
Co-head of the emerging and frontier markets team, Redwheel
EMs faced three main headwinds in 2022, namely, China’s zero Covid-19 policy, aggressive global monetary policy tightening and the Russian invasion of Ukraine. We see two of those three factors turning into tailwinds in 2023.
China has started to reopen its economy, therefore, the main question is the impact on the rest of the world. Additionally, we see the US Fed pausing hikes some time in the first half of 2023 and potentially pivoting to rate cuts in Q4, leading to a weaker dollar. The combination of a dovish Fed and the reopening of China’s economy creates a favourable backdrop for EM equities to outperform.
Additionally, we believe four key investment cases will drive EM outperformance this year.
First, is the accelerating emerging versus developed real GDP growth differential. EM economic growth will likely increase during 2023, bolstered by China and Latin America. In contrast, developed GDP growth is expected to decline close to zero. As a result, the EM vs DM growth differential should widen in 2023 and 2024. This sets a strong backdrop for EM asset prices.
Second is the weakening dollar. Going forward, we expect the Fed’s hawkishness will fade with decelerating inflation in the US owing to the owing to the lag effects of monetary tightening. As the Fed begins to become less hawkish and the ECB plays catch-up on tightening, the interest rate differential should gradually lead to a rotation away from US dollar-denominated assets. This historically has led to EMs outperforming the S&P.
The third investment case supporting the region is a global capex recovery after years of structural disinvestment. Corporates are recording an early stage uptick in investment as the capex depreciation ratio dipped to a record low in 2021.
Indeed, for developed equities the ratio fell below parity for 18 months, indicative of depreciating assets not being fully replaced.
EM relative outperformance has historically been a function of the global capex cycle given
that the sector composition is heavily skewed towards capex plays.
And lastly is attractive valuations. EM equities are trading on 11.5 x P/E ratios, cheaper than the 25-year average of 12.4 x. In contrast, US equities trade on a multiple of 17.6 x or above, the 25-year average of 17.1 x.
Lost and found
Looking at the longer-term picture, we believe we are on the cusp of an EM bull market after a ‘lost’ decade in the region. The culmination of the factors mentioned, though highly supportive for EM equities, would ultimately be sufficient to drive a phase of outperformance akin to the 2016/18 episode – which, albeit welcome at the time, lacked more structural pillars to prolong the rally.
History tells us that longer-duration EM outperformance is driven by earnings super-cycles, where sustained and superior dollarised earnings-per-share growth vs the US requires a seismic, underlying shift in the EM investment case.
We believe this is coming to fruition as the global economy increasingly separates into two major trading blocs, one broadly aligned to the US and the other to mainland China. We think there will be winners from this deglobalisation, and we consider three key themes: supply chain reorientation/nearshoring; energy diversification and independence; and secular growth stories benefiting from independent domestic demand growth, mostly rooted in demographics and infrastructure spending.
To conclude, EMs faced numerous macroeconomic and geopolitical challenges in 2022. Despite the recent obstacles, we feel the outlook for 2023 is positive as EM equities are in a robust position to outperform developed markets and deliver high absolute returns.
This article first appeared in the February edition of Portfolio Adviser Magazine
