Global emerging markets (GEM) experienced a challenging series of events in the past financial year with global monetary tightening and Russia’s invasion of Ukraine. A slowdown in China due to rising Covid cases and well-intended but disruptive regulations, not to mention the delisting risks for Chinese American depositary receipts (ADRs) also spooked investors. Overall, with these risks potentially at their peak presently, we believe GEMs are better placed for sustainable market returns over the medium to long term.
A more persistent inflation has been caused by an inability to re-balance demand and supply globally, exacerbated by social and political tension, has brought forward monetary policy normalisation. Central banks globally are facing a growth-inflation trade-off. Hiking interest rates rapidly risks triggering a recession, while not tightening enough risks causing unanchored inflation expectations so there remains a risk of policy error.
However, emerging central banks are better placed and have positive real rates given they moved early and aggressively in tightening monetary policy over the last year.
The Russia and Ukraine conflict has caused substantial volatility in GEM equities. Since the war began in February, risk aversion grew and the period that followed saw weak stock performance. Given that Russia is a large exporter of commodities, the conflict also led to dislocation in commodity prices, which for GEMs has resulted in some winners and some losers this year. The emerging European (Hungary, Poland, Czech Republic, Greece, Turkey) and Egyptian equity markets have been some of the worst performers given their dependence on Russian energy, grains, and tourism. On the other hand, with Russia no longer part of the MSCI Emerging Markets Index, producer economies of the Latin American region have benefited from higher commodity prices. Beyond Latin America, Saudi Arabia and South Africa have also recorded strong performance as they have the next-largest market exposures to commodities.
In China, the economy struggled amid a fluid Covid situation, regulatory crackdown on property and technology giants in the name of common prosperity, and delisting fears of Chinese ADRs in the US. A broad-based slowdown in demand raised economic growth fears. We expect a flood like stimulus in China but that is yet to be seen. Despite this downcycle, we see a good opportunity to buy quality businesses that may be trading at cheaper valuations. While China is slowing, its policies are favourable to promoting more sustainable growth to the world’s second largest economy.
Overall, despite these challenges, we believe that GEMs are in a better shape to withstand inflationary headwinds than in the past. Valuations and growth expectations have adjusted as decades of disinflation, easy monetary policy and asset inflation gave way to inflation/monetary tightening and lower growth expectations. GEMs offer the opportunity to create a diverse portfolio for any macro backdrop.
Looking ahead, we think this is an opportune time to invest in emerging markets – its equity index is now more competitive and at a healthier starting point in terms of valuations versus developed markets.
That said, we need to separate the wheat from the chaff by using active stock selection, based on fundamental analysis, to construct a portfolio of what we consider to be high-quality companies that can generate sustainable returns over the medium to longer term.