How emerging-market equities’ rebound rally could extend throughout 2023
The magnitude of 2022’s EM equities decline was a harsh reminder of the asset class’s volatility; the MSCI Emerging Markets Index dropped 20.1%, its worst result since the 2008 global financial crisis. Yet some of the key headwinds that buffeted EM equities began to ease in late 2022, and we believe a modest market rebound that played out in the fourth quarter reflects an increasingly brighter outlook for the rest of 2023. We see several early-stage catalysts—including improving prospects in Mainland China and a more favorable macroeconomic backdrop for the information technology sector—that suggest strong potential for an EM equity recovery.
An uneven path on the road to a potential recovery
Despite our overall positive outlook, we don’t expect a steady upward arc for emerging-market (EM) equities, given the potential for shifts in the forces currently driving global markets. After a difficult 2022 for all asset classes globally, we believe that 2023 GDP growth across developed markets (DM) is likely to weaken from 2022’s modest pace of economic expansion. In our view, the greatest uncertainty lies with the inflation outlook and the trajectory of declining inflationary pressures. As DM central banks continue to raise interest rates, we’re nevertheless mindful that the long-term structural drivers of inflation will continue to be fueled by supply chain shifts away from China, the protracted nature of Russia’s invasion of Ukraine, and the global push for decarbonization.
As for the United States’ influence on the EM outlook, one key source of uncertainty is how high the U.S. Federal Reserve (Fed) will lift its key benchmark lending rate before pausing its current cycle of monetary tightening. Another is the severity of a potential U.S. recession that many economists are expecting in 2023. A shallow recession will naturally create a relatively more constructive environment for equity markets to recover—particularly in EM, where there has been a historical correlation of strong EM equity performance following U.S. recessions. Should inflation dynamics be more benign than anticipated, a dovish pivot from the Fed is likely to create favorable conditions for quality growth equities.
Each of the past four U.S. recessions has been followed by an EM bull market
MSCI Emerging Markets Index price levels, January 1988–December 2022
Why we see a brighter 2023 in China
One of the major catalysts that contributed to an improved EM equity outlook was the Chinese government’s December 2022 lifting of restrictive COVID-19 rules that had slowed economic growth. While we don’t believe that recovery will be smooth, we believe that this long-awaited policy shift will provide a catalyst throughout 2023 as pent-up consumer demand plays out. Furthermore, it’s not the only significant tailwind that we see for the Chinese equity market, which is the largest country component in the MSCI Emerging Markets Index, with a 32.3% weighting as of December 31, 2022. Among the other tailwinds:
· Regulatory easing—In the wake of a government crackdown on Chinese internet companies, two important events have occurred. First, the nation’s online gaming regulator approved a slew of new domestic games in December and January. Those actions and subsequent approvals of imported foreign games appear to signal an end to the crackdown on the video games industry. Second, the government has signaled that Ant Financial, China’s largest payments platform, is now able to access capital markets after a 2½ year hiatus that marked the beginning of the regulatory crackdown on the sector.
· Monetary policy support—We expect the People’s Bank of China, the country’s central bank, will be more proactive and use appropriate liquidity tools to support the real economy. We also believe policy banks will take a more active role and provide greater support to the property market, which underwent instability in 2022, including falling residential and commercial real estate prices and credit stress.
· Low equity valuations—We believe that valuations remain low across several Chinese equity sectors owing to the amount of pessimism and elevated market risk premium that had been applied to Chinese assets. On the back of low valuations and an improving earnings outlook, we believe Chinese assets currently offer attractive opportunities.
Recovery potential in technology
In addition to China, information technology continues to be a sector where we see an abundance of EM equity opportunities in the wake of 2022’s dislocations. Top of mind for us are select high-quality technology companies that we view as long-term champions for innovation. Many of these companies—notably some economically sensitive firms in South Korea and Taiwan—endured an especially challenging 2022 owing to their vulnerability to softened demand for consumer electronics and to macro headwinds such as the strengthening of the U.S. dollar amid rising interest rates. We believe that recent easing of inflation and a potential shift away from currently restrictive monetary policies are likely to offer a more favorable backdrop for these companies through the rest of 2023, potentially leading to earnings reacceleration.
The strengths and weaknesses that 2022 revealed
Amid 2022’s many headwinds, it was of paramount importance for companies to demonstrate visible earnings growth, profit margin resilience, and the ability to optimize operational efficiency and profitability. In early 2023, we believe that many EM companies have emerged more resilient, as many have consolidated their strengths and are focused on improving their efficiency and profitability. We’re continuing to concentrate on businesses with solid balance sheets, resilient cash flow, and other sources of financial strength that could enable them to gain market share. Some of the businesses that we view favorably have recently been cutting costs while others continued to invest in technology, hardware, and research and development to advance their leading market positions.
A brighter EM outlook
Although we witnessed rapid dislocation in 2022, we transitioned into 2023 mindful of the opportunities that volatility can create for active managers seeking to identify great companies with attractive valuations. Over the long term, we believe that a stock’s market valuation is likely to ultimately trend to its fundamental intrinsic value. Despite today’s challenging EM environment, we nevertheless see plenty of early-stage tailwinds, and we view valuations across several EMs as compelling on both shorter- and longer-term metrics. Against this backdrop, we’ll continue to adhere to an investment framework focused on identifying high-quality, compounding-growth businesses while applying detailed due diligence.
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