EM Mid-Year Outlook: Why We’re Optimistic About a Rebound
Macroeconomic factors have weighed on emerging markets (EM) in 2022, but we believe changing conditions point to a brighter second half of the year into 2023.
The environment in China, a significant driver of EM performance, is improving as pandemic lockdowns ease and regulatory challenges recede.
We believe healthy earnings, peaking inflation, attractive relative valuations and a return to growth support our view.
Challenges Weigh on Emerging Markets
Hawkish monetary policy, the war in Ukraine and risks from China’s zero-COVID policies have weighed on EM in 2022. But as we enter the second half of the year, we believe emerging markets can rebound.
EM growth factors have been under significant pressure since March 2021. Inflation and subsequent tightening from global central banks have shifted the market narrative away from recovery and growth.
Figure 1 | EM Growth and Value Factors Diverge
EM Factor Performance
Data from 1/1/2021 – 5/27/2022. Source: MSCI. Growth is a component of the MSCI EM Growth Index. Value is a component of the MSCI EM Value Index.
Putting the factor rotation of the last 15 months into historical perspective, we can see how extreme the rotation has been in magnitude and duration. This rotation has continued into 2022.
Figure 2 | Historical Data Underscores the Rotation
MSCI EM Growth – MSCI EM Value, Monthly Returns
Data from 5/1/2007 – 5/31/2022. Source: FactSet.
Style Factor Movement Affects Performance
During the initial post-COVID recovery, equities were positively correlated with inflation expectations, but this correlation has turned negative. Figure 3 shows how the correlation of value factors to momentum is now at levels we haven’t seen over the last 20 years. Meanwhile, the correlation of growth factors to momentum has headed in the opposite direction.
Figure 3 | Momentum’s Correlations with Value and Growth Have Diverged
Data from 2/29/2000 – 5/31/2022. Source: MSCI, American Century Investments. Value is a component of the MSCI EM Value Index. Growth is a component of the MSCI EM Growth Index.
The Shift Away from Growth May Be Ending
While the latest U.S. inflation data is strong enough to keep the inflation story building, we believe inflation may be peaking. Headline CPI was up 8.3% year-over-year (YoY) in April and 8.6% YoY in May. (Source: FactSet.)
Further, lower two-year yields and a steeper yield curve likely point to a peak in hawkish policy. The growth factor has been very weak over the past year (as shown in Figure 1.) Thus, if we have seen peak aggressiveness by the Fed, we should start to see support for the broader growth equity indices.
All Eyes Are on China
The latest data show new infections retreating, mainly due to the lockdowns. China’s zero-COVID policy and insistence on prolonged lockdowns intended to rid the nation of the omicron variant have weakened its economy. If new outbreaks emerge, they may also bring about a stop/start pattern in economic activity.
Given the high transmission rate of omicron and the low efficacy of vaccines in reducing infections, China will need to continue high-pressure restrictions. Unless it is willing to attempt herd immunity or introduce more effective vaccines, lockdowns may persist.
Hence, China is faced with choosing between a strict zero-COVID policy and the spread of omicron. The former constrains economic activity, while the latter could overwhelm the health care system.
Macroeconomic Conditions Are Improving
Growth momentum decelerated sharply in April, yet the most significant disruption to production and trade activities has likely passed. Hard-hit Shanghai is reopening. Supply chain disruptions have dissipated, and production is resuming.
These developments should support a sequential rebound in economic reopening in the coming months. This is particularly true if the government refines its COVID restrictions, reducing transport and industrial production disruptions.
Uncertainties related to economic forecasts are high. COVID cases in China are declining because of the aggressive lockdown. Absent broader natural immunity, China risks locking down again if new cases ramp up with increased mobility.
Internet Sector Challenges Are Receding
Unlike previous years, when Chinese internet companies spearheaded earnings growth, we expect this year to be more broad-based. We continue to see opportunities in companies receiving strong policy support. We continue to favor areas along the green value chain and strategic investment areas, such as high-end manufacturing and technology self-sufficiency.
At the end of 2021, the Chinese internet space faced challenges resulting from rising uncertainty around regulatory, delisting and geopolitical risks. We are beginning to hold a more balanced view on certain stocks in this sector as significant uncertainties should start to subside. Over the year, we expect sentiment and fundamentals to improve within the Chinese internet sector.
Our Reasons for Optimism
We expect EM equities to perform better in the second half. Healthy earnings and a lower equity risk premium support this view, especially if Fed repricing is close to an end and inflation begins to moderate.
After the recent moves in equities and rates, we think EM equities have priced in much of the bad news. Valuations appear far more reasonable after the pullback.
Inflation may soon level off due to the transitory nature of the COVID impact and softening demand as growth slows. As the market prices in peak inflation and interest rates, the growth factor should return to favor.
We continue to favor a balance of cyclical and secular growth. We like traditional growth (e.g., technology, biotech and innovation) and cyclical stocks (e.g., metals and mining). Telecoms and financials, particularly banks, are attractive. Banks look well-placed to benefit from higher margins on the back of rising rates.
Despite the top-down pressure on risk assets, EM companies exposed to structural growth drivers, such as the energy transition, digital transformation and health care innovation, have continued to deliver strong revenue and earnings growth.
Second Half Looks More Promising
We expect to see opportunities in EM equities, especially if Russia and Ukraine reach a ceasefire. We note several constructive points if inflation peaks and cost pressures normalize, which would allow the market to focus on earnings rather than inflation and interest rate pressure.
Relative growth rates, which have historically supported relative performance, favor emerging markets. This view is reinforced as the U.S. appears to be on an aggressive tightening path while China is expected to ease its path, and its internet regulatory cycle is nearing an end.
Figure 4 | Relative Growth Rates Support the Outlook for EM Equities
Emerging vs. Developed Economies: Real GDP Growth and Equity Performance Spread
Data as of 5/31/2022. Equity performance data is from 12/31/2000 – 5/31/2022. GDP data after 2021 is estimated. Source: FactSet, IMF World Economic Outlook. Indexes compared are the MSCI EM Index and MSCI World Index. Forecasts are not a reliable indicator of future performance. Past performance is not indicative of future results.
Relative Valuations Favor Emerging Markets
Valuations are also attractive as equities have derated significantly this year. As of the end of May, the 12-month forward P/E of the MSCI EM was 11.57; 2021’s high was 15.6 (1/31/2021). That is a 26% decline. (Source: FactSet.)
Also, the relative valuations between EM and developed markets have cheapened significantly and are now more extreme than during the COVID outbreak in March 2020. (EM stocks are trading at a 33% discount to developed markets, relative to a 22% historical average discount.)
The market is beginning to price in much of the risks we have discussed. Figure 5 demonstrates how quickly emerging markets can rebound when valuations become significantly dislocated. We saw examples of this in 2012, 2017 and 2019.
Figure 5 | EM Price Momentum Has Room to Improve
Data from 1/31/2011 – 5/31/2022. Source: FactSet. Price information is in USD.
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