Add Emerging Market Strength in Global Weakness
Head of Portfolio Strategy David Dali explains why it’s an opportune time to add emerging-market exposure.
Market volatility has jumped in recent weeks. Strength in U.S. employment and inflation data has brought weakness to global equities as markets anticipate the Federal Reserve will keep rates higher for longer. We believe investors should use this volatility and future bouts of weakness to add emerging markets to their portfolio. Here’s why.
- Emerging markets can be defensive
Decoupling of emerging markets from the U.S. and developed markets can and typically does happen when the right conditions exist.
- The correlation of emerging markets versus the S&P 500 Index reached a four-year low in 2022 and Chinese equities correlations with the S&P 500 are close to 20-year lows 1
- Today, major emerging economies are on very different trajectories than those in developed economies largely because of their prior monetary tightening cycles and the easing of COVID restrictions in China
- We expect emerging markets to outperform U.S. markets if U.S. inflation and interest rates remain higher for longer
- China: Why it’s not too late
Outperformance of Chinese equities versus the S&P 500 since October 2022 has been significant and we believe it should continue.
- History tells us the recovery of Chinese stocks after a significant selloff can take as long as 24 months, so in our view it doesn’t pay to sell after the initial run-up
- Even after the bounce, Chinese equity valuations are still sitting at notable discounts
- The post-COVID recovery trade may still be at an early stage as Chinese consumers are only beginning to draw down the massive savings accumulated during the pandemic
- China’s monetary and fiscal policies are accommodative which should support equity prices
“We expect emerging markets to outperform U.S. markets if U.S. inflation and interest rates remain higher for longer.”
- Dispersion of returns beyond China
Investors have been focused on China's reopening story but many other markets may also benefit.
- Neighboring economies of South Korea, Taiwan and Japan can be supported by rebounding Chinese consumption
- Energy-, mining-, and food-export-driven economies such as Brazil, Indonesia, Peru and Chile can be valuable ballast in portfolio construction
- Mexico’s stock market has been the star so far this year, boosted by the strength of the peso against the U.S. dollar
- Valuations and earnings
Unlike many developed markets, most emerging markets (EM) equity valuations already assume significant risks related to prior years’ headwinds, such as China’s pandemic lockdown policy.
- As major advanced economies slip into economic weakness, halving their GDP growth rates to an aggregate of less than 1% in 2023, EM economies are set to maintain their strength just shy of 4%.
- This dynamic typically favors EM equity returns. We expect valuations— trading close to a 10% discount to five-year average—to melt-up as specific risks fade and earnings growth turns decisively positive later this year
- Risks are primarily external
We believe the risks to emerging markets today sit mainly outside of them.
- The U.S. dollar could be stronger for longer but many emerging markets have already proved themselves remarkably resilient to a robust greenback
- U.S.-China tensions are still an overhang but they are for most global equities markets and risk assets
- If developed market policy overshoots it could cause a mild or somewhat severe recession in the U.S. and Europe impacting demand for EM products. We expect EM equities could be more insulated than developed market counterparts during what would be a policy-induced downturn.
Head of Portfolio Strategy