A Year for Emerging Quality
CIO Robert Horrocks, PhD, says 2023 may bring more market stability and with it more appreciation of emerging markets assets.
Santa Claus rally? Bah! Humbug! Yes, why would we expect 2022 to end in anything other than disappointment? I mean, the latest inflation numbers were good, weren’t they? But the market just flopped and said: “A pair of socks? Thanks. What else you got for me?” This market demands more to get excited at Christmas. In fact, it’s acting a lot like a grumpy teenager.
To be fair, it’s got a lot to be grumpy about. Our global parents, China and the U.S., have not been getting on. After years of railing against China’s government subsidies to inconsequential traditional industries, the U.S. first imposed tariffs of questionable legality and then, when the World Trade Organization (WTO) pointed this out, it basically told the WTO that the U.S. gets to decide the rules. This was met with a round of applause from many in the U.S. and a chorus of “So what’s new?” from outside.
Over the years, corporate interests, for whom global trade often means competition, have succeeded in convincing other governments that they should look at trade the same way as the U.S. does. As always, those involved in international collaboration, as well as the consumer, get the short end of the stick as they can easily be persuaded that China is a military threat. And there is no reason to think that any of this will change in 2023.
How to deal with this? Well, steer clear of exporters unless you know they are dominant enough to pass on costs or flexible enough to reorient their supply chains. Domestic businesses are surely the place to be for the long run. When will this madness end? Probably when the price of smartphones starts to become unaffordable. In the meantime, and in an attempt to prevent us from overpaying for social isolation, there are going to be continued developments in infrastructure and manufacturing bases throughout southeast Asia, eastern Europe, and Latin America. In some of these economies, productivity and consumer spending should rise.
A sugar crash in the markets
Thankfully, I don’t have to deal with teenage grumpiness at home. When I asked my 17-year old boys what they wanted for Christmas, they answered: “Junk food.” If only the markets were so easily satisfied. Of course they would be if it weren’t for the withdrawal of easy money that has caused the sugar crash and, like with all teenagers, this has been the main focus of the markets.
So when will easy money come back? This all depends on inflation, which seems to be peaking. There is every reason to think that core inflation will continue to decline throughout 2023 even if there are more rate hikes to come—and there will be more hikes because that is how central bankers get evaluated by history.
So while there is good news on inflation with some commentators even muttering under their breath, “All along, I told you it was transitory….”, it seems that rates will continue to move higher for a while. I had thought we might get a bit of Christmas cheer on rates. Indeed, the currency markets have reacted with a weaker dollar, taking the pressure off some emerging market currencies. Other emerging markets are being supported by oil-money diplomacy.
We have had a pretty resilient currency backdrop to the U.S. tightening but it’s not enough for the current mood of recalcitrance. Why? Because we are potentially dealing with a global recession. The war in Ukraine, as we all know, has hit energy prices hard in Europe and it seems as though the European Union (EU) is destined for recession, and possibly a very steep one. The U.S. might skirt a deep recession but only because of a strong labor market, which is delaying the pause in rate rises that might make the world feel a little better. All of this is typically a difficult backdrop for emerging markets.
The one area where things are looking distinctly better at the moment is China’s domestic economy. As the government rolls back some of the more restrictive elements of its zero-COVID policy, consumer demand is returning. There will no doubt be occasional concerns that the pace of unshackling will slow as COVID deaths rise. However, some of the tight policies, particularly around the property sector, have been relaxed and we have seen some relief rallies in the markets on the back of that. So, whereas slower global growth is difficult for our markets on average, for China, our largest market, the cycle is moving in the opposite direction. All of this does work to counteract some of the pessimism out there and adds to the feeling that the world may just muddle on through.
“If we are now going through a period where the cycles start to calm down a bit, where policy swings are less pronounced, we might get to refocus on owning businesses.”
Old-fashioned returns back in vogue
And perhaps the overall backdrop is a little more healthy. After all, we have gone through several years of severe swings in the markets, lockdowns, stimulus, booms, inflation, tightening. All of which has basically got the markets focusing on “What happens next?” If we are now going through a period where the cycles start to calm down a bit, where policy swings are less pronounced, both in the West and in emerging markets, we might get to refocus on owning businesses. This seems to me to be an environment that should be helpful for our markets and for our approach to investing in them. For it is undeniable that the overall quality of businesses available to emerging market investors has continued to improve over the last few years. Whether it is a by-product of improving governance, government regulations, the listing of technological leaders, and the overall improvement of capital markets and the drive for efficiency in investment, there is a lot more diversity of quality businesses on offer in emerging markets than there was 10 years ago.
It may therefore be a time to look at some of the extremes in performance—whether it be the anomalously high valuations in India relative to the rest of the emerging universe, or the strong rallies in cyclical sectors, such as materials and financials and their support for some Latin American countries. Where these are justified by strong corporate fundamentals there is no concern. Where these are pricing in the latest sentiment around short-term momentum, there may be opportunities to trim and redeploy capital into long-term underappreciated corporate stories. And that may be the theme of 2023. For there are, it seems to me, plenty of areas where market prices continue to underestimate long-term business opportunities.
In a time where market cycles are short and violent, the idea of grinding out long-term returns seems old fashioned. But I believe that is where we should be focusing our efforts. That might seem a subdued message as we are impatiently tearing apart the wrapping paper to see what shiny gift lies inside. However, ultimately, it is the long-term health of emerging businesses that will sustain the markets, not just a few short bursts of excitement.
Robert Horrocks, PhD
Chief Investment Officer