Weekly Investment Commentary: Emerging investment opportunities
Bottom line up top:
- 2022: A global bear market odyssey. The havoc wreaked on global risk assets last year has become canon, with some of the worst pain felt across emerging markets equities and fixed income. Further complicating the investment environment for these asset classes was China’s struggle to contain the coronavirus and the adverse effects from the U.S. Federal Reserve’s historic rate hike cycle. The U.S. dollar strengthened as a result, making dollar-denominated debt more difficult to service. Both EM equities and debt saw their worst returns since the Global Financial Crisis, with the MSCI EM Index and the JPMorgan Emerging Market Bond Index falling 20.1% and 17.8% for the year, respectively. While the bear market may have taken a disproportionately large bite out of EM securities, we don’t expect them to be left behind when global markets eventually rebound.
- Emerging markets should recover. U.S. equity and fixed income markets may be poised to rebound ahead of their counterparts in non-U.S. developed markets, thanks to “being ahead of the curve” when it comes to monetary and Covid-related policies. Within EM, where central banks were generally one step ahead of the U.S. in terms of monetary tightening, we see a handful of developing trends that could provide a sound foundation for a recovery across asset classes, including: 1) optimism for a weaker U.S. dollar that results from moderating inflation and a slower pace and/or pause in Fed rate hikes; 2) better-than-expected economic activity out of China following the end of its “zero-Covid” policies; 3) declining correlations among the largest constituent countries; 4) manageable issuance on the debt side; and 5) an elevated starting point for yields in 2023, which could lead to robust total returns by year-end for fixed income securities.
“U.S. equity and fixed income markets may be poised to rebound ahead of their counterparts in non-U.S. developed markets.”
So far in 2023, returns for both emerging markets debt and equity have outperformed their peers in the U.S. thanks to a collection of tailwinds, including an accelerated reopening of China; improved risk sentiment toward credit and a weaker U.S. dollar. An improving economic backdrop across the EM landscape also underpins expectations of stronger returns as GDP growth of EM countries is set to outpace that of advanced economies over the next two years (Figure 1). Within EM debt, attractive yields and the increasing potential for interest rate cuts should continue to support strong total returns. Also, EM debt issuers servicing U.S. dollar-denominated debt could find additional relief should the dollar continue to weaken. Broadly speaking — with technicals remaining supportive, larger cash balances on the sidelines and the challenges associated with distressed sovereign governments largely priced-in — headwinds should continue to ease for EM debt this year, alongside global inflation.
EM debt is a wide and diverse asset class with opportunities across sectors. Within local markets, we are focused on countries that raised rates earlier, and in some cases more extensively, than the U.S. Fed. This has led to a more attractive foreign exchange profile. We currently favor EM corporate issuances over sovereigns thanks to elevated yields among high quality, well-established EM-domiciled issuers. Among issuers, we prefer those with sound balance sheets and exposure to solid macroeconomic fundamentals, while tilting toward positive reform stories. We also prefer issuers with exposure to diversified commodities, balancing that with countries fueled by higher domestic demand amid a normalizing of economic activity from the impacts of Covid-19. These positions should be more resilient given the potential for slower economic growth. Though the macro backdrop has improved recently, selectivity will remain key.
EM equities could be rewarding for investors who have the ability to move further up the risk spectrum in search of higher return potential. EME valuations are well below their long-term averages and remain inexpensive relative to the U.S., while forecasted EPS growth estimates over the next few years are notably more attractive than developed market counterparts (Figure 2). Entering 2023, earning expectations are negative for EM companies, the first negative forecast since 2009. However, with renewed optimism in China and potential for geopolitical issues to improve, consensus forecasts may be too conservative.
“Entering 2023, earning expectations are negative for EM companies, the first negative forecast since 2009.”
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