Assets from the emerging markets deserve more attention

The prospect of China’s economy turning the corner is providing support for the emerging markets as an asset class. But security selection is key as challenging conditions separate the wheat from the chaff.

High inflation and the war in Ukraine are weighing on economic growth in the industrialised economies and are proving a drag on performance in western capital markets. As a result, the spotlight is starting to centre more on the emerging markets. And this asset class could benefit from a recovery of China’s economy. The latest data for Chinese purchasing managers’ indices suggests that, after a tough struggle under Beijing’s zero-COVID policy, the economy has likely bottomed out for this year. Nonetheless, a comprehensive fiscal stimulus programme will be required in order to achieve the government’s target growth rate of around 5.5 per cent for the year as a whole. For a long time, Beijing seemed reticent in this regard, but high levels of youth unemployment are raising the pressure on the government to take action. China’s Premier Li Keqiang has called for further stimulus measures and President Xi Jinping may find it difficult to continue to ignore these demands. After all, the top jobs in the Chinese Communist Party will be reshuffled in October and the potential loss of prestige if China reported a lower growth rate than the US could be painful.

Another sign that points towards economic recovery is the fact that coronavirus-related restrictions have been eased significantly in recent days. In Shanghai, for example, shops and restaurants have been given the green light to reopen. The emerging economic recovery in China is likely to provide a boost to the entire Asian region. Against this backdrop, there is currently only limited potential for equities from industrialised countries to recover further. In a direct comparison, equities from emerging markets have thus gained in appeal.

EM share prices are bottoming out

A major plus point for EM equities is that valuations are at historically favourable levels. Since its high in February 2021, the asset class has come under substantial pressure and has fared particularly poorly when compared to US equities. This is due in part to the fact that many EM economies were propped up by less extensive monetary and fiscal policy support during the pandemic. Economic weakness and regulatory interventions and risks in China were another factor. In addition, the surge in commodity and food prices that was triggered by the war in Ukraine has hit certain emerging economies particularly hard. The US Federal Reserve’s interest-rate policy turnaround and rising US bond yields are also having an adverse impact.

Opportunities offered by assets from the emerging markets

High profit levels of EM equities

Opportunities offered by assets from the emerging markets
Source: Bloomberg, *calculated on the basis of the current P/E ratio, as at 23 June 2022.

But, measured by the MSCI EM index, equities from the emerging markets now seem to be bottoming out. Investor sentiment is very pessimistic, which can be a contraindication. Large volumes of investment have already been withdrawn from EM (equity and bond) markets, meaning that this asset class is currently not ‘overcrowded’. However, general parameters vary significantly, both between and within regions. Investors should therefore not only ensure that they have a very healthy capacity to assume risk, but also be careful in their selection of assets.

Higher commodity prices good for some and bad for others

In light of improved growth forecasts, we currently see opportunities for equities from China and also from Korea, which has close economic ties with China. Korea is an interesting proposition in terms of valuation and the fact that the country’s conservative party emerged victorious from the general election could pave the way for share prices to bottom out. Taiwan is a trickier case. Its technology-oriented economy benefited strongly from the surge in numbers of people working from home during the pandemic and now needs to weather a difficult period of unfavourable year-on-year effects. With regard to India, current high valuations do not appropriately reflect the inflation risk arising from steep jumps in the prices of agricultural goods and energy.

In the Middle East and Latin America, on the other hand, a number of countries are benefiting from their relative geographical distance from the war in Ukraine and their strong focus on commodities (energy, agricultural products, metals). Brazil and Chile offer opportunities thanks to a tailwind created by higher commodity prices and diminishing economic policy risks. Mexico, on the other hand, benefited disproportionately from US fiscal stimulus measures during the pandemic and could now suffer knock-on effects from weaker economic growth in the US. Some African and Middle Eastern countries, such as Egypt and Pakistan, are struggling with the impact of persistent disruption to the supply of food from Russia and Ukraine.

EM bonds offer attractive yields

EM bonds also offer opportunities. Although many countries are facing significant fundamental challenges in the aftermath of the pandemic, we expect that adverse pressure from elevated US yields and the appreciation of the US dollar will ease. The risk/return profile of EM government bonds is currently favourable, both for paper denominated in hard currencies and for local-currency bonds. The turmoil that unfolded in the markets between the start of the year and May 2022 has driven yields on hard-currency bonds to levels not seen since the initial panic at the start of the coronavirus pandemic in March 2020.

Opportunities offered by assets from the emerging markets

Attractive spreads on EM bonds

Attractive spreads on EM bonds
Source: Bloomberg, *calculated on the basis of the current P/E ratio, as at 23 June 2022.

Measured by the EMBI Global Diversified index, EM bonds offer a spread of around 500 basis points, which is attractive compared with the long-term average. This creates potential for a positive total return in the coming years. Calmer conditions in the US interest-rate market could have a favourable effect on the considerable duration in the segment for EM hard-currency paper. Country selection is important, especially when it comes to weaker candidates from the single-B rating pool that could come under significant pressure if US-dollar bonds were to experience a rise in yields and a drop in liquidity. Among these are countries such as Pakistan, Kenya

and El Salvador.

By contrast, we have confidence in countries that can credibly reassure investors about their ability to maintain fiscal discipline over the longer term, for example Côte d’Ivoire, Mexico and Indonesia, and in beneficiaries of higher commodity prices such as Brazil, Saudi Arabia and Nigeria. A marked absence of issuers in the primary market and the resulting meagre supply of new paper is also supporting EM bonds. In this challenging market environment, issuers have to offer new issue premiums again in order to be able to place their bonds successfully.

 

As at 23 June 2022

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