Global stocks have been correlated to the downside, but Portfolio Manager Josh Rubin says emerging markets equities may recover before developed markets.
Observations in Emerging Markets Equities
I’m Josh Rubin, portfolio manager at Thornburg Investment Management. 2022 has been a year where global equity markets have been quite correlated – unfortunately to the downside. But Emerging Markets do have their own economic and political drivers that are separate from Developed Markets. Our observations of what’s happening on the ground give us confidence that Emerging Market economies can recover sooner than Developed Markets, and that equity valuations in EM could improve in 2023 and beyond.
One of the most important capital market drivers in 2022 has been inflation. A common stereotype is that inflation is a challenge for Emerging Markets but not for Developed Markets. But EM policymakers have learned a lot from the financial crises of the 1980s and 1990s. As a result, they’ve been pursuing very orthodox and disciplined monetary policy for the last 20 years, including last year when the world re-opened from COVID. This time around, EM central banks are actually now ahead of the curve compared to Developed Markets.
Inflation across the major Emerging Markets has been less volatile and is only modestly elevated compared to historical trends. More importantly, because EM central banks have generally been aggressive at raising interest rates to contain inflation, several EM economies already have positive real rates, and others are not far away.
Unfortunately, there remains a notable divergence between inflation and interest rates in the major Developed Markets. They still need to see a more substantial increase in interest rates or a meaningful decrease in inflation to return to positive real rates.
Altogether, we expect inflation is likely to peak and soften in Emerging Markets sooner than Developed Markets. And this has historically been an attractive set-up for EM. Another common concern about investing in EM is the risk of depreciating currencies, but many EM currencies have held up better to a rapidly appreciating dollar than their Developed Markets counterparts this year.
Several factors have contributed to this currency resilience. First, Emerging Market countries navigated COVID with much less stimulus than the developed world, which has protected their sovereign balance sheets.
Additionally, EM countries have become less reliant on trade with developed economies over the last decade, so they can continue to grow even while demand has softened in Europe and the US.
These healthy fiscal and trade dynamics have combined with EMs’ proactive monetary policies to mitigate currency weakness in this cycle, particularly compared to international Developed Markets. The Chinese and Indian currencies have weakened notably less than the euro, yen and against other major Developed Market currencies, and the Brazilian real has actually strengthened against the US dollar.
More stable currencies also help buttress economic activity, so this is another reason to have confidence in a recovery in EM economic growth before Developed Markets rebound.
Politics have also been center stage in Emerging Markets this year. China just wrapped up its 20th Party Congress. President Xi Jinping was elected to an unprecedented third term, and his influence is clear. Now that we have good visibility into who will be leading the country for the next five years, we expect more information on their economic and regulatory objectives to trickle out over the coming months and into the spring.
Meanwhile, voters in Latin America have shown their preferences for more centrist policies: Brazil just elected a left-leaning President who will be governing with a new center-right Congress. We expect compromise to result in more centrist policies than markets feared earlier in the year.
Let’s move on to valuations, which have declined substantially in 2022 across both EM and DM. But something to keep in mind is that before the US and EU started to pursue zero interest policies after the Global Financial Crisis, equity valuations around the world used to be fairly close. Over the last decade, Emerging Markets maintained higher interest rates, which led to EM equities trading at a discount.
Today, EM equity valuations look attractive relative to local interest rates, historical equity valuation levels, and when compared to Developed Markets – which now need to earn their cost of capital since the days of 0% rates are over.
While we often talk about “Emerging Markets” as a singular asset class, EM is actually comprised of more than 20 diverse countries whose valuations have diverged over the last three years.
Political and economic uncertainties have dragged down Chinese and Brazilian equity markets to the low end of their 15-20 year valuation range, but we now have greater political clarity in both countries, which can reduce relative valuation discounts. China sustainably re-opening from its zero-COVID policy is another key driver for next year.
On the other hand, India’s valuations have been elevated this year, due to economic re-opening, continued confidence in IT services and manufacturing offshoring, contained inflation, and a notably bullish domestic investor base. These drivers were enough offset 2022’s global trends of higher energy prices and higher interest rates – which would normally be headwinds for India.
While this has been a frustrating year for Emerging Markets equity investors, it’s worth keeping a few points in mind. First, EM has traded as a risk-off asset class, but elements of that risk – inflation and currency volatility have been constructively contained. Second, because EM fiscal and monetary policy-makers never put the pedal to the metal during COVID, they don’t need to slam on the brakes now either. EM economies are well-positioned to reaccelerate in 2023 and beyond.
Finally, EM equity valuations have been compressed by high local interest rates and political concerns. The set-up is now reversing, which can also be a tailwind for EM equity valuations.