It’s tempting to think of ‘emerging markets’ (EM) as one homogenous group of countries which move in lockstep with one another. The reality is more of a mixed bag – each country and region is at a different point on their journey to industrialisation.
Among some 150 developing economies, the 25 largest - including Brazil, India and China – account for 70% of the population and 90% of GDP in the group. Over the past two decades, investors showed their willingness to overcome difficult operating conditions to access large domestic markets or companies that benefit from cheap labour pools – led by the promise of rapid growth as these economies played catch-up with more mature developed markets.
COVID-19 changed the narrative: risk aversion and uncertainty during the pandemic saw capital flows to emerging markets grind to a sudden halt – non-resident portfolio flows show the largest EM outflow ever occurred in the first quarter of 2020, exceeding the worst points of the Global Financial Crisis (IIF). While inflows began to recover in April 2020, boosted by monetary easing in major developed markets, investors were selective in their approach – focusing on less vulnerable economies with effective COVID containment measures. In 2021, EM as a group failed to participate in the ‘everything rally’: the MSCI EM Index fell 2.2% while the MSCI All Country World Index gained 19.04% (in USD). In reality, this was largely driven by weakness in China – ~40% of the index at the start of 2021 – which fell 21.7% amidst regulatory action against large technology companies and for-profit tutoring. Other countries in the index held up well: 15 delivered positive returns; 7 delivered returns above 20%.
Inflation has been the headline act of 2022, with emerging economies expected to face a peak inflation rate of 11.0% in the third quarter of this year. Higher global commodity prices have put pressure on net commodity importers – including India and the Philippines. While net exporters – including Indonesia, Malaysia, Brazil and the Gulf Nations – have seen their terms of trade and FX reserves improve. Tighter monetary policy conditions to combat inflation have helped drive the US dollar up ~10% this year against a basket of other currencies. This is bad news for many emerging economies. With more than 80% of all EM external debt denominated in a foreign currency (mostly USD), a strong dollar increases the cost of servicing ‘hard currency’ liabilities in local currencies (FSB). This comes through in the numbers: both hard and local currency EM debt markets suffered a fifth consecutive quarter of negative returns in the third quarter. Despite these headwinds, the IMF forecasts EM growth at 3.7% this year – ahead of previous crisis years in the 1990s and early 2000s.
Moving into 2023, there are reasons to be constructive on EM. While commenting on the likelihood of US recession is beyond the scope of this article, it is clear that if weakness in the US economy leads the Federal Reserve to ‘pivot’ and reduce interest rates, we should see downward pressure on USD – to the relief of many emerging economies. Likewise, improved sentiment towards China should support the case for EM recovery. The Chinese government has outlined a 20-step plan to slowly transition away from its unpopular and costly zero-COVID policy and the tail risk of a property market crash looks to have been meaningfully reduced with the introduction of a 16 point plan - allowing banks to extend maturing loans to developers and provide additional funding to ensure completions of pre-sold homes (crucial as pre-sold homes account for c. 90% of total activity in the housing market) (The Economist Intelligence Unit). With a lot of bad news already priced into valuations – MSCI China is trading close to Global Financial Crisis levels at approximately 12x forward price to earnings – improved investor confidence could see a meaningful re-rating across Chinese equities – and possibly beyond.
The 25 largest emerging markets are well placed to withstand a period of weaker global growth - only a small minority have a deficit to be concerned about (above 3% of GDP) and FX reserves are close to 26% of GDP (vs 19% in 2013). At a micro level, Bank of America research suggests leverage among EM companies is at its lowest level in a decade (well below US corporates), with interest coverage ratios at their highest level since 2012. Domestic demand will become even more important if global growth slows; countries like Indonesia and the Philippines (more domestic demand oriented by nature) are well placed to benefit from rising consumption and continued reopening tailwinds post-COVID.
Short-term uncertainty is unlikely to derail the long-term structural growth trends in EM – population growth, higher disposable incomes (shifting many millions of people from poverty into middle class lifestyles), greater levels of education, higher levels of foreign direct investment, etc. The Economist Intelligence Unit forecasts 3.9% average annual GDP growth in non-OECD economies to 2026 (vs 1.8% for OECD nations). Beyond this, most emerging markets in Asia are expected to grow GDP by 2-3% p.a. to 2050 (against 1-2% for the US and Western Europe). Challenges certainly remain – uneven regional development, inequality and low social cohesion, poor infrastructure, FX volatility – and the direct and indirect costs of doing business in certain markets will remain high (ICAEW). However, in the largest emerging economies, continued structural reforms should lead to an improving investment climate and higher business confidence. As they transition to become fully industrialised countries over time, growth through productivity gains will become more important – with domestic production shifting up the value curve from low-wage assembly to more complex (and profitable) products.
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