Investing in Emerging Markets

[윤영준]

Emerging markets had one of their longest bear markets in 2022 with the MSCI EM Index down about 40% from its February 2021 peak and the first time that EM bond index has had two consecutive years of negative returns since 1994. As a consequence, there was a significant outflow from EM funds, the worst level since 2008. There are three factors behind this dismal EM performance: aggressive interest rate tightening from the Fed and other central banks, the Russian invasion of Ukraine, and China’s zero-Covid policy and property sector slump. The combination of elevated inflation, high interest rates and weak external demand may still weigh heavily on EM economies in early 2023. But the tide could be turning as evidenced in January. Two out of the three factors are likely to switch from headwinds to tailwinds in 2023, while the war in Ukraine remains uncertain and may reach stalemate. Whereas the near-term picture appears challenging due to geopolitical risks and tight financial conditions, we believe a more constructive scenario for EM economies in the mid-term.

With a weak global economic growth and lower global risk appetite, there may be more pressure on EM assets in the first half of 2023. But later in the year, investors can expect a recovery in EM assets amid declining risk premia and a shift in monetary policy. Cyclical winds are also shifting in favour of emerging markets as global inflation appears to ease more quickly than expected. We anticipate monetary policy becoming a more positive factor as the weak economic backdrop and decelerating inflation prompt policymaker to likely pivot to interest rate cuts later in 2023 or early in 2024. Thanks to the readiness of EM central banks to react to changes in inflation and inflation expectations as early as in 2021, inflation in EM is likely to decline towards its long-term average faster than DM. Historically, emerging markets tend to recover before the developed markets when an economic cycle turns. And there has been a close relationship between an expanding growth premium and relative stock market returns. As the growth differential this year will be the largest in a decade, it will favour EM over DM. The gap between EM and DM GDP growth according to IMF is to widen from 1.0% in 2022 to 2.6% and 2.7% in 2023 and 2024, respectively. Hence, this sets a strong backdrop for EM assets to outperform DM assets over the next years supported by a more robust growth potential.

Since 2000 a strengthening dollar has been headwinds for the emerging world, and vice versa. The performance of emerging markets relative to developed markets stocks has behaved almost like a geared play on the dollar — EM outperforms when the dollar is sinking, as happened during the lengthy commodity-driven rally of 2002 to 2007 and underperforms when the dollar is rising. We believe that dollar has peaked in 2022 and its long-term downtrend has already started. It is still possible that dollar may try to regain its strength as risk appetite remains subdued in the early part of 2023. However, once the Fed achieves its target rate by the middle of 2023 and stops its hiking, dollar will weaken especially against EM currencies, which becomes tailwinds for EM assets.

EM assets were particularly hit hard from China’s zero-Covid policy, property sector slump and regulatory crackdown. Because China is a major trading partner to virtually all other EM regions, and accounts for one-third of the market capitalization in most EM benchmark indices, its fate weighs heavily on investor willingness to allocate to EM. We anticipate a more pro-growth, stimulus-oriented stance in China. China will begin prioritizing economic development over some of its goals related to security and social stability. This is already evident by Covid-related policy initiatives and increased support for the real estate sector. A re-opening already allowed private consumption to rebound substantially and is expected to boost China’s GDP growth. While the steps of the Covid reopening journey seemed opaque, the destination is rather clear. China is the world’s second-largest economy and accounts for over one-third of global growth. Hence, strengthening China helps the rest of the emerging world and tends to weaken the dollar. Once China really resumes to function with full vigour, that could stoke demand for commodities. In addition, some EM countries can benefit from the US-China conflict as the reorganization of strategic supply chains could create new opportunities for EM nations other than China. Neutrality to geopolitical conflicts allows them to trade across both sides of international conflict and to benefit from friendly shoring of manufacturing such as India, Mexico, and Vietnam.

In 2022, EM equities and bonds sold off on heightened risk aversion associated with geopolitical risk, reactive Fed monetary tightening and the strict zero-COVID policy in China. As a result, EM equity valuation has reached at its historical low with the MSCI EM index trading at about 10 times forward earnings estimates. While 2023 is set to see the global economic backdrop remain challenging, we expect three positive inflection points: US monetary tightening, Chinese mobility constraints and lower global inflation. An improvement in these global drivers should enhance investment sentiment and push EM multiples to be rerated from current depressed levels. This leaves EM equities well-placed to deliver strong absolute returns and to outperform DM. In an uncertain environment of high interest rates, slowing growth and volatile markets, high quality investment-grade EM bonds also offer an attractive entry point for modest but positive total return with lower volatility in the first half of 2023. As always, the heterogeneity of EM means that active management remains key to success.

[좋은세상]

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