Emerging markets faced a number of headwinds in 2022, namely, China’s zero Covid-19 policy, aggressive global monetary policy tightening (led by the US Fed) and the associated rise of the US dollar.
We believe these factors are now turning into tailwinds that should persist over the next 12 to 18 months at least. Indeed, after something of a lost decade for emerging market (EM) equities, at least relative to US equities, this cyclical turning point in EM could usher in a multi-year period of outperformance. We note that EM performance cycles have typically moved in multi-year waves of underperformance followed by outperformance. We see the structural case for EM (that is, a rising middle income “consumer” class) as still very much intact.
China Re-opening a Cyclical Catalyst for EM
China is still in the early stages of economic re-opening. We note that investors have tended to underestimate the GDP and earnings growth leverage stemming from economic re-opening. The consensus expectation is that China GDP growth accelerates from 3% in 2022 (likely overstated) to 5% in 2023. We see upside risk to this 2023 estimate based on the experience of other countries as they have “re-opened”.
The prospect that Chinese growth will be picking up while the entire western world will be slowing down is supportive of a dynamic that will generate rising foreign investor interest in Chinese, Asian and EM equities, we believe.
China is the world’s second largest economy and accounts for over one-third of the EM investable universe. The prospect of China re-opening is likely to be a key catalyst for many Asian/EM economies and stock markets in both 2023 and 2024. We anticipate that China’s re-opening will benefit many companies across the Asia/EM investment universe.
We see positive spill-over benefits to many key countries in the Asian region via improved China import demand and outbound tourism. A surge in goods and particularly services spending should impact travel-related companies in China, as well as companies in other countries that are beneficiaries of Chinese tourism, such as Indonesia, Vietnam and Thailand. The removal of Covid restrictions provides a significant boost to stocks leveraged to Chinese consumption.
Some are suggesting China’s re-opening will have a significant effect on the commodity market. However, we see China’s re-opening as more consumer-led and therefore think China (consumer-focussed) exposure and exposure to other Asian markets will be a superior way to play the China re-opening story than via commodity exposure.
China’s Domestic Policy Pivot alongside the Re-opening Theme
China’s peak governing body has announced several policies to address the country’s economic malaise, in addition to the relaxation of the zero-Covid policy. This includes significant credit support for the property sector and a loosening of regulation on internet platform firms.
Although much negativity surrounded President Xi’s unprecedented third-term post at the 20th National Party Congress, these supportive measures demonstrate that the leadership has brought economic growth back into sharp focus. When Xi unveiled the new government, the market was overrun by the pessimism that China would relegate economic growth and corporate profitability. The mantra of China being “un-investable” gained credence around last year’s October party conference. The MSCI China index is up 52% (total return in US$) since this foreign investor consensus.
We see China’s political, economic and Covid policies as now being relatively aligned in support of growth and a healthy corporate sector. This should assist China to continue the recent outperformance trend going forward.
For the second largest market in EM, India, the long-term investment case has progressively strengthened in recent years and we believe the market provides a strong structural growth story. Valuations are not cheap, but this needs to be calibrated against a strong earnings growth outlook.
Accelerating Emerging vs Developed GDP Growth Differential
We believe that economic growth is likely to increase in EM during 2023, bolstered by China and to some extent Latin America. In contrast, we think developed markets (DM) GDP growth is expected to decline close to zero. As a result, the growth differential between EM and DM will widen in 2023 and 2024 in both a GDP and earnings sense. This potentially sets a strong backdrop for EM asset prices.
Fed Pivot as a Catalyst for US dollar Decline
As a second key catalyst, we believe the Fed is likely to pause its hiking cycle around the middle of 2023, with a likely pivot to rate cuts sometime in the second half of 2023. This should lead to a weaker US dollar, which appears significantly overvalued against most currency crosses.
The interest rate differential moved in favour of US dollar-denominated assets in 2022 as the Fed raised policy rates more rapidly than its developed market counterparts. On the other hand, China continued to ease monetary policy and is still doing so. The flow of capital to the US accelerated when the Fed signalled a tighter monetary policy than the markets were expecting through much of 2022.
Going forward, we expect that the Fed’s hawkishness will fade due to decelerating inflation in the US due to the lagged effects of monetary tightening. As the Fed begins to become less hawkish, the shifting interest rate differential should gradually lead to a rotation away from US dollar-denominated assets. This historically has led to EM outperforming the world.
Emerging markets would benefit from an extended period of dollar weakness. The trend in the US$ has tended to be an important factor in respect of whether EM outperforms or underperforms developed world markets. We see the underlying drivers of this relationship as multi-faceted, and including: (1) the drag on local currency EM cash flows from a rising US$; (2) portfolio outflows from EM to the US when the US$ is strong; (3) debt pressures in some EM markets when the US$ is strengthening; and (4) the tendency for US$ strength to coincide with either risk-off or slow global growth periods.
Emerging Markets: Cyclical and Structural Potential
In summary, we feel the combination of a pivoting Fed, a weakening US dollar and the reopening of China’s economy creates a favourable backdrop for EM equities to outperform.
As news flow surrounding China becomes incrementally more positive, we believe investor sentiment towards emerging markets should progressively improve. Many EM economies are undergoing a rapid process of industrialisation, as did other Asian economies before them, and the EM middle (consumer) class continues to grow. Alongside China’s reacceleration, many EM countries’ resilient internal growth drivers are likely to shield them from the slowdown in the global economy, while the rapidly growing middle class across much of EM provides strong structural appeal. As has traditionally been the case, prudent active management is likely to produce superior results in EM.
Written by
David Cassidy, Head of Investment Strategy
David is one of Australia’s leading investment strategists.
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