Although emerging markets underperformed developed markets in 2022, if you strip out China, emerging markets actually performed in line with the developed world[1]. While China grapples with its own unique challenges, emerging markets, generally, have proven resilient despite the spectre of inflation. Moreover, inflation in emerging markets was lower than in the developed world in 2022, bucking the historical trend. Many years of loose monetary policy, rising debt, shrinking workforces, and structural imbalances borne of onerous welfare commitments, have left developed markets vulnerable; and the crises of the last few years have exposed that vulnerability.
In contrast, emerging market policymakers are used to dealing with inflationary environments and a certain degree of market volatility and have pursued prudent macro policies.
Markets are set to rebound in 2023, after demand was supressed last year by aggressive policy tightening in much of the world. However, the challenges of decarbonisation, deglobalisation, uneven demographics, and record high debt burdens will continue to dominate the agenda in developed economies. In particular, the developed world's supply-side vulnerability is likely to result in medium-term inflation settling higher and growth at lower than historical levels.
We expect emerging markets to do well in 2023. In addition to trough valuation and light investor positioning, we expect the growth differential between emerging and developed markets to expand driven by favourable demographics, manufacturing capabilities, and availability of critical resources, all underpinned by supply side reforms and investment in infrastructure. Growth, however, will be challenging as central banks unwind loose monetary policies and governments are unable to pursue large-scale fiscal stimulus. Against this backdrop, we expect emerging markets to perform initially boosted by the reopening of China as the Beijing authorities abandon zero-Covid, as well as a rebound in South Korea, Taiwan and Brazil, and supported by the stability of India, Indonesia and Mexico.
Chinese equities are approximately 25% cheaper compared to the historical average[2]. The Chinese market can perform in 2023 if the economy re-opens and policymakers successfully stabilise the property sector. As the US Federal Reserve begins to slow the pace of interest rate hikes, headwinds from a strong US dollar are likely to subside. Having started the tightening process early, we expect several Latin American economies to ease monetary policy in the second half of this year. Asian economies ex-China are likely to lag initially but most will probably catch up in the second part of the year as the global slowdown begins to bottom out. We expect South Korea to benefit from stabilising global growth, considering that the market substantially sold off in dollar terms (-31%)[3] in 2022 and we expect Taiwan to benefit from a rebound in the semiconductor cycle in the second half of this year. Economies in the Middle East are likely to prosper as the re-opening of China stabilises global growth, driving the energy sector, which is also constrained by a long-term lack of investment and the Organisation of the Petroleum Exporting Countries' (OPEC) renewed grip on supply.
Over the medium- to long-term, we forecast a shift in the investment environment, which we anticipate will be decisively different from the previous decade.
Underpinning this shift will be higher-than-normal inflation and cost of capital, along with sticky supply-side constraints (energy, commodities, and labour), to which investors will have to adapt. The shift is likely to create winners and losers at the global, regional, and sectoral levels. While developed economies are learning to adjust to inflation, emerging economies have a golden opportunity to improve their competitiveness - and capitalise on their position as leaders of global growth, utilising demographic advantages, manufacturing prowess, and access to resources.
While the market is likely to focus excessively on the impact of the re-opening of China's economy, and the prospect of a less hawkish US Federal Reserve, as well as possible rate cuts in the latter half of 2023, we are taking a much longer view on investing in emerging markets as we have lower conviction in the sustainability of the current market narrative. We are, therefore, dedicating our time and effort to looking beyond the near-term momentum and focusing on opportunities and challenges that are likely to materialise over the medium- to long-term.
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[1] MSCI EM ex-China index (-19.3%) compared to MSCI World (-19.5%) as at 31 December 2022
[2] MSCI China P/B 1.3x vs. historical average 1.75x as at 31 December 2022
[3] MSCI Korea in US dollars as at 31 December 2022
