Q1 2022 CIO Review and Outlook
CIO Robert Horrocks, PhD, sees resilience among emerging markets in these tough times.
It might seem at first that everything is against emerging markets. The dollar is strengthening and long bond yields are falling as two-year bond yields rise, causing the yield curve briefly to invert—a sign of a central bank squeezing excesses out of an economy. Added to this, the 30-year mortgage rate has soared recently. That will hit the housing market. And fiscal policy, too, has turned tight, which may hit consumption.
None of this bodes well for the U.S. economy in the short term—recession is possible, even likely. The tensions between the U.S. and China continue and have been exacerbated by Russia’s invasion of Ukraine. Indeed, it is an extremely difficult backdrop for emerging markets in general.
Unsurprisingly, valuations have correspondingly fallen and that gives us a meagre degree of comfort. However, more comforting is the fact that emerging markets have only marginally underperformed the S&P 500 year to date despite the weakness in China and the extreme losses in Russia. Indeed, equities seem relatively calm about all of these events. Partly, I am sure, this reflects the market’s continued belief that inflation will start to cool—for inflation expectations, although they have risen, remain high for the short-term only. So, the market, on average, still believes that supply-chain issues and possibly labor shortages and labor mismatches are largely the cause of higher prices and will be rectified within 12 months. Partly, too, though, it seems that emerging markets on average may be far more resilient to external shocks in this downturn than their reputation suggests.
Strength in Brazil
Let’s take Latin America to begin with. These markets have performed quite strongly, particularly the major market of Brazil. It’s tempting to put this down to the performance of resource stocks—and they have certainly played a part as commodity prices have risen both with the general inflationary environment and with a fear of shortages after sanctions were imposed on Russia. These are commodity-producing countries and so they tend to do well at times like this. However, over the past quarter, other sectors have performed just as well—notably financials. And some sectors, particularly in the service sectors, have performed even better.
So, the recovery in Latin American markets has been far more broad than just commodities. That is perhaps partly because they lagged Asia’s markets for much of the COVID-19 lockdowns and so the rally, as abrupt and as broad as it has been, has not extended valuations too much and indeed, in general Latin America still trades at a discount to Asia. Of all the Latin American economies, perhaps at this moment Mexico is best placed for long-term sustainable growth. In recent years, Mexico has done much to strengthen its macro economy and its position close to the U.S. will continue to be advantageous in the shifting of global supply chains.
Turning to India, it has continued to outperform. This has been largely due to a rebound in earnings as well as a more stable currency due to a stronger current account picture. The current account in turn has been helped by better performance in manufactured exports, both automobiles and increasingly lower-end electronics goods. However, the oil price shock is a negative and the current account has moved back into deficit but the currency continues to be stable. In summary, it’s not as good a picture as it was a few months back but the performance of India’s markets is holding up.
Other parts of Asia, too, have seen relatively strong performance—Singapore, Indonesia and Thailand to name a few. This is not that unusual as Asia often performs well just in advance of U.S. Federal Reserve rate hikes, for economic growth is often accelerating at such times. The general reflationary environment tends to help Asia’s economies and their stock markets. It tends to be favorable for smaller companies over large caps. Once you look through the commodity price shocks and rise in risk aversion, all of these expected trends appear to be playing out.
China, perhaps, has been the main drag on emerging markets this year. Its weak performance can be attributed to several things: tight monetary policy over the last couple of years; regulatory actions by China’s government; de-listing worries; and tensions surrounding Russia and the Ukraine and the possible implications for Taiwan.
Let’s take that last point first, because it is a question many clients have posed. Absent any provocation—such as a declaration of independence by Taiwan—we believe a military takeover is extremely unlikely. It would not be straightforward militarily and the potential damage to China’s economy through the loss of high-end semiconductor supply makes it a costly proposition.
Regarding the monetary situation in China, it has been tight for most of the last two years. This has surely been a difficult backdrop for some of the regulatory initiatives. However, both fiscal and monetary policies are loosening, and China, not suffering from inflationary pressures, has room to persist with moderate stimulus. With stimulus, I expect accelerating earnings growth, even amid a zero-COVID policy.
As for the regulatory issues that plagued some of China’s mega-cap stocks, the government has admitted that it could do a better job of signaling and consulting on regulatory initiatives. This is helpful to investors as it makes the legislative landscape a little more predictable. China’s issues are, like many developed economy’s issues, related to supporting the private economy to generate wealth and maintaining a competitive market, and at the same time intervening to spread the benefits of that wealth more widely.
On concerns about possible forced delisting of Chinese stocks from U.S. markets resulting from the U.S.-China auditing dispute, it seems as if the Chinese are going to allow fairly widespread inspection of auditor’s books. As such China will meet most of the conditions that the U.S. wants. It remains to be seen whether it is politically possible to achieve a final agreement before the mid-term elections. However, it must now be a matter of time and if companies were to transfer from a U.S. listing to a Hong Kong listing—for many current stocks this is a mere administrative matter—ultimately, the prices will be set by Hong Kong and domestic Chinese investors. Overall, this issue seems largely to be a waiting game and there is in my mind some value here.
So, looking across the major emerging markets it seems that there are good reasons why they have remained resilient. Valuations are back to where they were in late 2018, and there has been a distinct improvement in returns of equity. Indeed, we are currently only about 10% more expensive than levels in broad emerging markets that over the past eight years have been a pretty solid floor for valuations. So, if we are to see better earnings growth in our markets, the prospects do look tempting.
On a broad measure of emerging markets and the U.S., valuations are now at similar discounts as they reached during the global financial crisis. However, within the emerging markets there are no clear reasons to favor one region over the other from looking at valuations alone. Indeed, the relative outperformance of Latin American markets has simply clawed back some of the historically high premium that Asia had enjoyed in recent years.
The big impact has been the vicious shift from growth to value (and cyclical value). As commodity stocks and particularly banks have rebounded and earnings expectations have improved, so the valuation premiums on technology stocks and health-care stocks have shrunk dramatically. Whereas more value-biased portfolios have been able to weather this storm, the majority of the portfolios we run have a growth bias and performance has consequently suffered.
There are two things to say about this. First, we do not think this is the time to go chasing short-run, cyclical growth. The market can easily whipsaw back and hurt us as these stocks correct. Far better to stick with our long-term growth philosophy. Second is to look through the companies in our portfolios to check that the operational performance of the businesses is still strong. For the surge in cyclical and value stocks may very well be linked to current inflationary pressures.
The bond market continues to tell us that it thinks this is a relatively short-term environment and even, on some measures, that inflation has peaked. If that’s the case then it is not unlikely that we return to the environment that preceded the pandemic lockdowns—one of disinflationary growth. That environment in the past has proved to be a time when valuation premiums for growth stocks have risen.
It’s always been our focus at Matthews Asia to look at the long term and to focus on businesses that will deliver sustainable growth. And as challenging as times seem right now, we still see opportunities in all of our markets.
Robert Horrocks, PhD
Chief Investment Officer