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Outlook

Emerging Markets Should Be Well-Positioned for 2023

Josh Rubin
Portfolio Manager and Managing Director
22 Dec 2022
6 min read

Looking ahead, emerging market valuations are relatively attractive versus developed markets as EM central banks are better positioned in the struggle against inflation.

After a highly volatile year, we expect a relatively calmer 2023.  We expect many of the major headwinds that faced emerging markets in 2022 will likely moderate going forward, although we are mindful that other challenges may arise.  Over the past year, valuations across emerging markets (EM) have fallen significantly from their 2021 highs and look attractive relative to historical levels and when compared to developed markets.  Even as global growth slows, we believe EM equity valuations have room to improve in 2023, driven by lower inflation, a peaking U.S. dollar, greater clarity around key political events, and structural shifts within the region.

Evolving Supply Chains and Proactive Monetary Policies Should Dampen Price Pressures

We do not expect the same inflationary shocks that occurred in 2022 to repeat in 2023.  Stabilizing oil prices, improving global food supply, and recovery in supply chains should help lower inflation, as well as overall slower growth, weaker demand, and normalized labor markets.

Central Banks Are Not Behind the Curve on Inflation

Source: Bloomberg
Baskets are proxies for countries’ policy rates and inflation indexes.
 
 

Since EM central banks were ahead of the curve in pushing orthodox monetary policies throughout COVID, inflation is only modestly elevated versus historical trends, and real rates remain in positive territory across many major EM economies.  As a result, emerging markets seem poised to enter easing cycles earlier than developed markets because of their central banks’ monetary discipline.

Emerging Markets Valuations Varied in 2022, but are Generally More Favorable Heading into 2023

Valuations across EM diverged throughout 2022 with India trading at a noticeable premium to other markets like China, Brazil, Taiwan and Korea.  Taiwan and Korea faced headwinds this year due to the export-oriented nature of their economies.  Political uncertainty was a significant overhang in both China and Brazil, which has led to Brazil trading at its lowest valuation in over 10 years.  At current levels, the latter markets’ valuations are relatively attractive versus local interest rates, historical levels, and developed markets.  Looking ahead to 2023, we expect those markets to re-rate.  Taiwan and Korea should be beneficiaries of a recovery in the semiconductor and hardware technology sectors.  Brazil could be the first major EM outside of China to enter an easing cycle next year.  Meanwhile, China’s exit of its zero-COVID policies should be a huge boon to that country.

Emerging Markets P/E Ratios Varied in 2022, but Should Reset

Source: Bloomberg

 

Emerging Markets’ Currencies Resilience Should Support Economic Growth

Many EM currencies performed relatively well against a rapidly appreciating dollar this year compared to their developed markets counterparts. Several factors have contributed to their currency resilience. First, emerging market countries navigated COVID with much less stimulus than the developed world, which protected their sovereign balance sheets. Second, EM countries have become less reliant on trade with developed economies over the last decade, so their economies can continue to grow even as demand softens in Europe and the U.S.

These healthy fiscal and trade dynamics, combined with EMs’ proactive monetary policies, have mitigated the impact of the strengthening U.S. dollar, particularly compared to international developed markets. The Chinese and Indian currencies have weakened notably less than the euro, yen and other major developed market currencies, and the Brazilian real actually strengthened against the U.S. dollar in 2022.

More stable currencies also help buttress economic growth, which is another reason we have confidence of a recovery in EM economic growth before developed markets in 2023.

Emerging Markets Currencies Are Holding Up Relatively Well against the Dollar

Source: Bloomberg
 

EM Politics Remain a Priority for Investors, but a Little Less Muddied

Politics will continue to remain top of mind next year as we continue to closely watch events unfold, particularly in China, Brazil, Chile and Russia-Ukraine.

In China, President Xi Jinping was elected to an unprecedented third term in October 2022, thus strengthening his influence over the government.  Now that we have visibility into who will lead the country for the next five years, we await further clarity on Beijing’s economic and regulatory objectives, particularly around the country’s zero-COVID policy and property market.  China has announced a series of easing measures towards both issues throughout November and December 2022. Concerning the former, China is preparing its citizens to learn how to live alongside COVID – by applying more targeted virus containment, increasing the number of beds in COVID-designated hospitals, and speeding up its vaccine campaign.  In addition, Chinese regulators issued comprehensive guidance on easing financing for the property sector, which should help stabilize property sales and starts in the coming months.  We expect more widespread and concrete announcements will be made in March at the 10th National People’s Congress.

Meanwhile, voters in Latin America have shown their preferences for more centrist policies.  In September, Chileans voted to reject a left-leaning constitution, and we anticipate that next year will bring a more centrist draft and possibly another vote.  Brazil elected a left-leaning President in October who will have to govern with a center-right Congress.  Corporations and capital market investors will closely monitor Chile’s constitutional debate and Brazil’s centrist stance next year, amid hopes that more middle-of-the-road outcomes may establish concrete expectations for future investment opportunities.

While we do not have greater insight than others on the conflict between Russia and Ukraine, any resolution will be positive for investor sentiment.  Not only will energy prices and food supplies normalize, falling geopolitical tensions would drive risk aversion levels lower.

Emerging Markets Are Themselves a Source of Diversification

While we often talk about “emerging markets” as a singular asset class, EM is actually comprised of more than 20 diverse countries.  Even the composition of MSCI EM constantly shifts around, especially after two years of dislocation created by a global pandemic.  At the end of October 2022, China’s index representation in MSCI EM Index fell to just below 27%, the lowest since early 2017, while the combined weight of Korea, India and Taiwan reached a 20-year high.

This diversification means upside opportunities abound throughout the region.  Different countries will benefit from different trends, such as structurally higher commodity prices and multipolar world investing.  Meanwhile, it is important to be mindful of idiosyncratic drivers for specific markets, such as India’s social and economic infrastructure buildout, the Middle East’s reform agenda, and China’s shifting growth model under Common Prosperity.  Attractive opportunities within emerging markets can be identified through active investing, and we continue to expect strong businesses with high quality growth prospects to perform well in 2023.

Outlook

China

COVID lockdowns continue to take a toll on growth and fuel investor uncertainty. China concluded the 20th Party Congress in October with President Xi Jinpeng elected to a third term. While short-term uncertainty remains elevated, the potential for a robust economic reopening in 2023 represents a unique catalyst.

India

Indian equities continue to be resilient amid global uncertainty, but equity valuations remain expensive relative to both EM peers and their longer-term historical average.

North Asia

Export-driven markets in North Asia, such as Taiwan and South Korea, face challenges as softening expectations for global growth pressure global trade.

Latin America

Inflation, domestic interest rates and political uncertainty appear to have peaked across much of the region, yet valuations still remain below historical averages.

EEMEA

Tailwinds from rising energy and commodities prices are abating but select opportunities across the region remain attractive.

Positioning

China

Amid zero-COVID, we favor laggard reopening stories and compounders, who may benefit from a reopening in 2023. We remain cautious on Internet names and companies with elevated levels of regulatory/policy uncertainty.

India

Elevated valuation levels limit the number of attractive opportunities relative to other EM markets. We continue to target Indian companies that fit our characteristics of a strong business and trade at reasonable valuations.

North Asia

Underweight the region, especially companies more exposed to external growth and the broader semiconductor cycle.

Latin America

Improving economic dynamics, increased political clarity, and attractive valuations are providing opportunities to establish positions in a variety of strong businesses where prices have dislocated from fundamentals.

EEMEA

Underweight the region, but finding select opportunities as the economic landscape stabilizes.

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