By Samantha Barnes, International Banker
It was Queen Elizabeth II who, in her annual speech on Christmas Day in 1992, famously declared that the year had been an annus horribilis following a series of infamous disasters and scandals that plagued the British Royal Family. The late British monarch may also have been referring to a year in which the country crashed out of the European Exchange Rate Mechanism (ERM), and the sluggish UK economy at the time barely escaped a deep recession that had emerged around 18 months earlier. Fast forward 30 years from that sobering assessment, and one might be inclined to apply the same description to 2022, a year in which double-digit inflation and aggressive interest-rate hikes threatened another prolonged recession—and the grim spectre of stagflation—taking hold.
But it was the world’s emerging markets (EMs) that had perhaps the most rightful claim to declare last year an unequivocal annus horribilis, as a combination of hugely influential global events, including the war in Ukraine, the steep monetary tightening enacted by most central banks, a surging US dollar throughout much of the year and China’s economic slowdown following the adoption of its stringent zero-COVID policy, weighed heavily on the sector. With investors shunning EMs through most of the year, the benchmark MSCI Emerging Markets (EM) Index crashed by around 20 percent as governments fell into default; currencies weakened dramatically against the soaring dollar, which, coupled with skyrocketing prices, pushed import costs for necessities such as food and fuel to the heavens; and double-digit losses were recorded widely across EM stock and bond markets. Indeed, by late October, the index had fallen by roughly 40 percent from its February 2021 peak.
But with the MSCI EM Index sharply reversing course in the final quarter, there is growing consensus that EMs could once again prove an attractive investment this year. Between late October and the end of the year, the MSCI EM Index managed to claw back almost 15 percent as China began to refocus its priorities on revitalising economic growth whilst also gradually relaxing its COVID rules as part of its bid to reopen the Chinese economy.
With this encouraging recovery taking hold during the fourth quarter, EMs may well be able to kick on and deliver further gains in 2023. For one, it would appear that China will continue on its path towards fully reopening, such that economic growth will once again be buoyant this year. “If you look at the savings rate for China right now, it’s very elevated,” Erik Zipf, head of emerging markets equities at DuPont Capital, told Reutersin late December. “We think that’s going to get spent as soon as people feel comfortable to go out, that’s going to provide a pretty big tailwind from an economic perspective.”
According to Morgan Stanley economists, moreover, China will begin to prioritise economic development over its security and social-stability goals, which have taken centre stage for the past two years. “We…see a possible end to China’s zero-COVID policy by the new fiscal year in April 2023,” Lisa Shalett, Morgan Stanley Wealth Management’s chief investment officer, wrote in November. “A full re-opening could allow private consumption to rebound substantially and boost China’s inflation-adjusted GDP growth from below 3 percent to 4.5 percent in 2023.” Shalett also emphasised that, with China’s COVID response being markedly different from that of the West, it has not suffered from high inflation or rising interest rates. “This gives Beijing [a] significant runway for stimulus.”
It also seems as if the US dollar peaked last year. With the Federal Reserve (the Fed) likely to continue easing its rate hikes in the coming months as inflation cools, a further weakening in the greenback should enable EM currencies to recover this year. “As the dollar potentially weakens, EM countries could benefit from the relative appreciation of their own currency,” Morgan Stanley’s Shalett added. “Additionally, commodity exporters, such as countries in Latin America, could see commodity prices strengthening due to greater global demand.”
Indeed, Latin America represents the EM that may prove most resilient, especially given its strong performance last year compared with other regions. “During the latest EM bear market, the MSCI EM Latin America Index declined just over 5 percent through Jan 23, its smallest drawdown of any EM bear-market period going back to 1997,” Morgan Stanley’s investment strategist, Christopher Baxter, noted on January 24. “The region’s average decline during EM bear markets over that period was 41.7 percent.”
As with much of the global economy, however, Latin American (LatAm) central banks are likely to continue struggling to tame inflation sufficiently, while weak growth is expected to put considerable pressure on countries’ budget finances. Nonetheless, LatAm should weather these challenges more resiliently than most EM regions. It is also worth noting that with inflation peaking around June 2022 for most LatAm countries, which was moderately earlier than much of the rest of the world, central banks in the region have been able to correspondingly begin easing off on their rate hikes earlier than others.
“LatAm stands out from across EM as major central banks in the region should start to ease monetary policy and thus softening the blow to growth stemming from a global slowdown,” J.P. Morgan noted in its “Latin America Outlook 2023”. “Furthermore, supportive commodity prices could also offset some of the impact, as China’s economy reopens post-COVID lockdowns. Structural shifts such as nearshoring should also support FDI and hence help keep current accounts in check.”
Deloitte also observed that the region has benefited from a surge in commodity prices thanks to strong demand following the reopening of the global economy. “The region grew by 6.8% in 2021 with GDP of half of its countries surpassing pre-pandemic levels,” Deloitte noted in its “Latin America economic outlook, January 2023”. “Then, in 2022, the war in Ukraine broke out, which has decelerated this recovery. However, we still forecast an economic expansion of 3.4% for LatAm in 2022.”
In terms of investing in the region, LatAm is also currently home to opportunities with highly attractive valuations, as stocks continue to trade cheaply compared to both their own historical valuations and their global peers. “Latin America’s 12-month trailing price-earnings (P/E) ratio, at 7.0, is just off its lowest level since 2008 and compares favourably with both the broader MSCI EM Index’s average of 10.5 and the S&P 500 Index’s 18.9,” Baxter also recently observed. “They are poised to outperform EM stocks broadly. In the past, when Latin American equities have traded more cheaply than the MSCI EM Index at bear-market troughs—as they recently did, by the widest margin in more than 20 years—the region’s stocks have gone on to beat the broader EM index by a median 20 percent to the next cycle peak.”
Morgan Stanley is also particularly bullish on emerging Asia, which it believes has already begun leading the EM complex into a new bull cycle, with the weakening US dollar and China’s more sustainable COVID-management policy underpinning the region’s bright outlook. “We are confident that we are at the beginning of an emerging-market bull cycle,” Jonathan Garner, Morgan Stanley’s chief Asia and emerging market equity strategist, wrote in late December. “As in previous cycles, we expect this to be led by the large North Asian markets—China, Korea and Taiwan.” The bank also highlighted that valuations remain relatively cheap, with stocks underperforming last year in the Korean and Taiwan markets.
But while the outlook certainly seems rosier for EMs over the coming months, pertinent risks to the downside could well scupper gains for the sector this year. The impact of the Ukraine war will continue to reverberate around the globe for years to come, with the rejigging of supply chains among the clearest consequences. With talk of new strategies such as on-shoring, friend-shoring and near-shoring gathering pace in recent months as viable solutions to fix broken supply chains, a far less globalised model is likely to continue materialising this year.
These solutions might ultimately benefit emerging markets in the long term by driving the creation of new trading relationships. But should governments persist with them, the lengthy and costly processes of shifting supply chains closer to home may not be particularly economic in the near term, as companies spend resources finding alternatives that are more geographically conducive to new supply-chain policies. As such, EMs may feel considerable pressure over the coming year as this transition gets underway.