Q1 2023 CIO Review and Outlook
CIO Robert Horrocks, PhD, says emerging markets and China are charting a course of opportunity for investors as developed economics are buffeted.
- China’s reopening didn’t spark the resurgence in emerging markets that some investors hoped for. But the first quarter was marked by corporate restructuring and capital market reforms in China that should have positive long-term investment ramifications.
- Divergence in the fortunes of developed markets and emerging markets is an embedded trend the signs of which can be seen now.
- Looking ahead, not only will macro swings likely be less pronounced but also emerging markets will likely reward businesses with quality franchises.
While China’s reopening didn’t quite trigger the resurgence in emerging markets equities that some investors hoped for, the first quarter was notable for other reasons. The breakup of Alibaba, the planned listings of JD.com’s business units and similar, future corporate actions that other China behemoths may take, should encourage a refocus on business. That could raise efficiencies and returns on equity and ultimately achieve higher aggregate market valuations for the separate entities that emerge.
We also saw the initiation of plans for Hong Kong listings denominated in Chinese renminbi which will improve connectivity between the mainland and offshore market. Taken together, these market reforms and corporate actions say a lot about where China and the emerging markets are heading and, I believe, give reason for long-term investors to take heart.
For China, better-functioning capital markets are required as it seeks to build wealth and increase the efficiency of investments as consumption takes over a higher percentage of gross domestic product (GDP). A better welfare system, too, can be financed with savings that work harder. And all of this in turn should increase the efficiency of China’s economy as well as the overall quality of its listed companies. So, even as the headlines around China concentrate on foreign policy and Taiwan, and issues of democracy versus autocracy, in the background China continues to modernize and look a little more like the West economically.
For emerging markets, China’s embracing of some developed-market infrastructure may ironically lead to a change in global trade dynamics. As China becomes more like the West, economically at least, the impetus to trade with the West may diminish. China will become more technologically capable of producing more high-end goods itself. And better efficiency across the board will continue to make services, many of which are not traded, an increasingly larger share of China’s economy. It points to China becoming a more independent economic force where the economic ties with the rest of the Asian region, and perhaps Latin America and Africa too, strengthen, as ties with the West become less important. The tension between the U.S. and China—largely the product of fear on both sides—may further encourage the economic world to slowly separate into two spheres.
“Growth differentials between emerging markets and the West may start to widen later this year, and more importantly earnings per share growth may be superior in emerging markets in a way it has not been for years.”
This is a long-term view but these trends may be exaggerated in the immediate market environment by starkly different economic conditions in the major protagonists. The knock-on effect of the recent banking failures in the U.S. will surely be additional tightening to what the Federal Reserve has already done. Bank lending standards were already tightening—some banks had pulled away from mortgage lending altogether and now deposits have started to flow into money-market funds that can yield between 4%-5%. So, lending in the U.S. is likely to be further squeezed even as we may start to see the first impacts of a slowing housing market on construction jobs. This will present additional headwinds for a U.S. economy already grappling with a slowdown.
In China, in contrast, the emergence from lockdown means that cities are starting to buzz again. While we are not yet seeing this impact in the published financial results of many companies, CEO outlooks and analyst briefings are noticeably more optimistic in tone. This leads me to suspect that growth differentials between emerging markets and the West may start to widen later this year, and more importantly earnings per share growth may be superior in emerging markets in a way it has not been for years.
Valuation opportunities in Latin America and Asia – including India
In the face of this potential improving trend, valuations are by no means demanding, either in terms of profits or asset values. Even the perennially expensive-looking India has seen its valuations fall. Although it remains more expensive to the rest of emerging markets, and the gap between it and China is relatively significant, that difference can be somewhat excused by the better quality of economic performance in India, including better export performance and a more credible and stable monetary system.
In Latin America, where economies have often been seen as most vulnerable to monetary tightening, even here some of the frailties seem to be in the past. Brazil actually began its tightening cycle ahead of the U.S.; Mexico, one could argue, was running very controlled fiscal and monetary policy for some years in the run up to the recent inflationary spike. These economies have stored up some goodwill with economic actions that should serve them well in coming years.
When we look at core inflation and currencies in Southeast Asian markets, inflation has stayed stubbornly low and currencies have often been unusually stable as a result. It is entirely possible that some of the debt restructurings in marginal emerging markets and frontier economies may cause some issues. They might even serve to further knock confidence in emerging markets as a whole. But this is not your grandad’s emerging markets; indeed they seem far more resilient than even the emerging economies I remember when I first began investing.
Emerging markets can chart their own course
Looking more broadly at the global macro landscape, what we have seen is a whipsawing of monetary and fiscal events–incredibly loose during lockdowns followed by some of the fastest monetary tightening on record as we emerged from those lockdowns. This has caused big swings in the markets. When loose policy is followed, companies with a current-day narrative and remote prospect of sustained earnings do well. When there is severe tightening, the market tends to focus on the tried-and-true, cash heavy businesses.
I believe a more balanced monetary environment is taking shape. Not only will macro swings likely be less pronounced but also markets will likely reward businesses with quality franchises—those with more immediate earnings and cashflow that nevertheless are likely to sustain for far longer than current market participants are prepared to believe.
Undoubtedly many of the ongoing challenges of recent years—U.S.-China tensions, the war in Ukraine, inflation and now slowing economic growth—are still in view but economically speaking emerging markets seems to be moving along, driven by rising consumption, China’s reopening, new sustainable industries and accommodative monetary policy. And in China, the seeds of capital reforms are being sown that could encourage greater availability of high quality domestic corporate champions in local capital markets. To my mind, this all makes the emerging markets harder to ignore from an investment point of view.
Robert Horrocks, PhD
Chief Investment Officer
As of 3/31/2023, accounts managed by Matthews Asia held positions in Alibaba and JD.com