Emerging Market (EM) equities suffered heavy losses in 2022 driven by monetary tightening, a stronger US dollar, broad economic slowdown and the consequences of the Russian invasion of Ukraine. While the difficult environment we are observing this year amplified concerns around investing in EM, the downturn began already at the end of 2020. It started with the regulatory crackdown in China which affected multiple technology companies including Alibaba, Tencent and Meituan. Issues related to housing market and the zero covid policy caused the overall picture to deteriorate further.
However, the landscape appears to be improving. The most recent developments (including relaxation of quarantine measures, a notable change in narrative around covid stance combined with a potential softer approach related to wider tech regulation) are early signs of gradual change to Chinese policy which may trigger a long awaited pivot moment for EM equities.
The performance of the broader EM complex is strongly linked to the inflation backdrop. The US CPI print of 7.7% combined with loosening of quarantine restrictions in China triggered much awaited rebound in emerging markets equities. Leading economic indicators tell us consistent story of moderation of inflation in the US. In our view, this may have a profound impact on developing economies and equities. In the short term the uncertainty will likely remain elevated, but If the disinflationary episode in the US persists, the pressure on the FED will ease and this may trigger a long awaited US dollar depreciation which in turn will support EM equities, as well as the underlying economies.
Figure 1: MSCI EM and MSCI World Index Performance (in USD)
The underperformance has led to significant improvement in valuations over the last two years and on a number of metrics MSCI EM Index screen inexpensive, trading at undemanding 12m forward P/E of 11.6x which translates to a generous forward earnings yield of 8.6%. This is even more appealing when put in the context of weak currencies and (despite all headlines) a decent economic growth ahead.
Figure 2: MSCI EM 12m forward Price to Earnings
Global economies are slowing down and emerging markets are not an exception in that regard. However, despite the global slowdown, EM countries are expected to deliver a robust GDP growth of 4.0% in 2023 followed by a 4.4% in 2024 according to Bloomberg consensus. That stands in contrast with a sluggish expansion of 0.5% and 1.5% expected in the developed markets over the next two years. China (30.4% of the MSCI EM index) remains a major economic force, an exporting giant and a leader in intellectual property. The country is expected to grow by 4.9% in both 2023 and 2024. India (14.9% of the index) has been a bright spot this year as it was less affected by raising energy prices. It will likely continue to be a leading economic force with 6.6% growth expected for the fiscal year 2022 followed by a strong growth of 5.7% and 6.9% over the next two years according to OECD. Other EM economies particularly important from an equity standpoint including Taiwan (14.4% of the index) , South Korea (12.0%) and Brazil (5.4%) are expected to enjoy softer economic expansion but still above growth levels of developed countries between 2022 and 2024. Expected growth of EM economies combined with undemanding valuation of EM equities present interesting inflection point for investors with a medium term investment horizon.
Figure 3: Forecasted Real GDP Growth
The EM equity story becomes even more interesting when we consider FX moves in 2022. Rapid depreciation of the majority of EM currencies against the US dollar had a detrimental effect on equity performance and on emerging economies as it exacerbated the impact of raising oil prices. For that reason the inflation outlook in the US is the pivotal element in the EM equity story. SSGA Economists expect a disinflationary episode ahead and If the consumer prices in the US continues to fall and do so in a rapid pace, the currency component should contribute to the performance of EM equities. In addition, potential US dollar weakening will ease the above-mentioned pressure coming from high oil prices.
Figure 4: EM Currency performance relative to US dollar year to date
EM equities are dominated by APAC (78% of the index) which despite economic slowdown remains the engine of the global growth. Key catalysts for a rebound include moderation in inflation and gradual change of covid stance in China. The EMEA and LATAM components include Brazil (5.4% of the index), Saudi Arabia (4.1%) South Africa (3.8%), and Mexico (2.4%). These countries complement EM Asia exposure with a commodity tilt which offer a cushion against short term volatility.
Figure 5 MSCI Index breakdown by region
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