Investment Strategy:  Third Quarter 2022Emerging Markets – Facing the wall of worry

Emerging Markets – Facing the wall of worry

Rising interest rates and a strong US dollar are the traditional headwinds for emerging market economies and their investors; so coupled with rising political tensions in India and continued COVID lockdowns in China as well as rolling off a decade of meagre investment returns, have emerging markets become too easy to ignore?

The invasion of Ukraine by Russia will be harmful to emerging market economies in several ways. With war decreasing the risk appetite of many investors, emerging markets have suffered from their higher risk/reward nature with steady flows out of the asset class, particularly in emerging markets debt which has seen outflows of $21 billion in the six months to April 2022.

The rising price of commodities brings a mixed blessing for emerging markets. For many emerging economies, purchasers of commodities who have turned away from Russia have had to seek alternative sources of supply whether that be energy or grains, which has been beneficial to some emerging market countries such as Brazil, South Africa and Saudi Arabia. On the other side of that trade, those countries who had been dependent on Russian energy, grains or indeed tourists have all been weakened, affecting the likes of Hungary, Czech Republic and Turkey. And those such as Egypt provide a good example of how rising oil and food costs have the potential to create problems from both a financing and societal perspective. Egypt’s finances will come under pressure as it continues to subsidise fuel prices as well as facing gaps in its wheat supplies given 50% of all its wheat consumption comes from Russian and Ukrainian wheat imports. The threat of rising food prices raises the spectre of the Arab Spring in 2010/11 when riots broke out, due in part at least, to rising food costs.  Whilst Egypt is not alone in this regard, rising fuel and food prices pose a particular challenge for some parts of the emerging world.

A China slowdown is clearly an issue for the global economy as it will continue to drive supply disruptions, but it is a major headache for emerging market equities with China representing about 30% of the MSCI Emerging Markets Index. Earnings expectations are stagnating, driven by a weakening outlook in China given the lockdowns that remain in place. As China moves out of its COVID lockdowns it has the capacity to stimulate its economy and there will be clear political demand for this to take place later in the year as the Party Congress takes place. Stimulating an economy whilst lockdowns are in place makes little sense, so seeing some relaxation of its draconian pandemic policies will pave the way for the stimulus plan it surely needs if China is to get anywhere near its official 5.5% growth target. In the meantime, the MSCI China Index fell by 50% between February 2021 and March 2022 and whilst it has recovered somewhat since, Chinese equities trade at 1.4x price/book and a forward price/earnings ratio well below global equities and also below the broader emerging market index. Whilst there may be questionmarks raised against the validity of corporate earnings expectations across all equity markets as growth slows, consensus earnings estimates for next year are for Chinese corporate earnings to grow, in marked contrast to developed market peers.

Wilting in the face of a strong US dollar is a character trait of emerging market assets. Emerging market central banks have moved by raising rates in advance of developed markets to an extent they haven’t historically done. Whereas developed market central banks appear behind the curve in terms of their interest rate policy as they reacquaint themselves with the challenge of taming inflation, emerging markets central bankers find inflation a more familiar foe and have been on the front foot, proactively raising rates to the point where there is some headroom for interest rate cuts to act as a support for economies should growth stutter in the face of a rising dollar. It should also be noted that interest rates are rising, in particular in the US, to tackle a high inflation problem and not due to strength in the US economy which emerging market countries could benefit from by selling manufactured goods to the US consumer.

As the chart shows, emerging markets have been left behind by the US, tech-led rally that has been the predominant feature in markets over the last decade or so. Extrapolating recent trends is a fools errand. The returns from emerging and developed markets have swapped places over the last two decades with very different experiences for UK investors. From a valuation perspective, their starting points today look relatively attractive versus their history but the coming months are likely to see a number of challenges as we go through this period of heightened uncertainty driven by central banks and the consequences of the invasion by Russia of Ukraine. For long-term investors, who can see through that, emerging markets will remain higher risk/reward, but are also looking more attractive than they have done for years.

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