Emerging market (EM) equities faced heavy pressure from late 2020 by the regulatory crackdown in China, followed by zero-COVID policy, strengthening of the US dollar and the war in the Ukraine, which added to the risk-off tone. After two painful years and continuous disappointments, EM performance has begun to turn. More importantly, this improvement is driven by powerful forces that will likely remain in the medium to long term. Looking at performance, EM equities have significant potential to catch up with the developed world given the improved backdrop.
Figure 1: MSCI EM vs. MSCI World Index Performance (in USD)
As much as China, which represents a third of the MSCI EM Index, had been a source of EM issues, the country now offers a solution to them. The faster-than-expected reopening removes the key headwind and may allow China to unlock the potential of its economy and to contribute to further supply chain easing in the medium term. As we pointed out in our Q1 2023 Sector and Equity Compass, the end to the zero-COVID policy will have a profound impact on both the Chinese and global economy. While market participants appeared to have initially underappreciated this development, now (unsurprisingly) we have started to see improvements to Chinese GDP forecasts.
The China reopening coincides with a less stringent approach toward tech regulation. This shift is pivotal for the EM equity complex, as some of the largest MSCI EM Index constituents faced Chinese regulations and therefore sold off since late 2020. A continuation of the softer stance may benefit not only tech giants but also the broader technology sector, as it will encourage (or stop discouraging) new investments. In the short run, this new environment could cause volatility – as we observed in February – due to increased competition among Chinese companies; however, in the long term, we believe a lighter touch from Chinese regulators will lead to a more healthy business environment and, as such, is a key element of the EM equity story.
Through the reopening, China is repositioning itself to become, once again, the engine of the global economy. While the growth among global developed markets will be modest at best, we expect the expansion of EM economies to be fairly robust. We have already noticed upgrades to economic forecasts and would not be surprised to see a continuation as activity returns to normal levels.
But EM growth is not only driven by China. India (13% of the MSCI EM Index) is expected to enjoy even stronger growth during the next two years. The forecasts for EM economies such as Taiwan (14% of index), South Korea (12%) and Brazil (5%) point to stronger growth for each of those countries relative to developed markets in 2023 and 2024. While EMs tend to grow faster than advanced economies, these projections look particularly appealing given broader growth scarcity among developed economies.
Figure 2: Forecasted Real GDP Growth
The inflation path is impacting EM economies in a number of ways. In the most important countries within the MSCI EM Index (China, Taiwan and South Korea), we expect the inflation slowdown to continue over the next two years. Another important consideration is inflation in the US, as elevated levels led to monetary tightening and strengthening of the US dollar, which naturally had a detrimental effect on EMs.
The moderation in inflation has begun to reverse that trend and, while the January US CPI number of 6.4% may seem like a miss, economists at State Street Global Advisors expect the continuation of inflation moderation and note that there is too much seasonal noise around both January and December prints. Slower inflation should lead to the end of rate hikes and, potentially, the weakening of the US dollar against EM currencies over the medium term.
Valuations for MSCI Emerging Markets remain undemanding relative to the developed world. While acknowledging that EMs historically traded at a discount given a higher risk-reward profile, the economic growth advantage makes the current valuation discount particularly attractive relative to developed markets.
The key medium-term risks to the EM equity investment case include:
While we do not expect any of these scenarios to materialize in our base case, such factors need to be monitored.
Figure 3: MSCI EM and MSCI World 12-Month Forward Price to Earnings Multiples
EM equities are dominated by EM Asia countries (79% of the index), which, amid economic slowdown across developed markets, remain the engine of global growth. The EMEA and LATAM components include Brazil (5.2% of the index), Saudi Arabia (3.9%), South Africa (3.6%) and Mexico (2.5%). These countries complement EM Asia exposure with an exposure toward commodities, a necessity against higher demand for natural resources stemming from China reopening.
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