Emerging market review and outlook – equities and fixed income
Overall emerging market growth is likely to be lower going into the new year, but we believe active management could continue to build a compelling emerging market case for global investors.
Key equity insights:
Key equity insights:
- The US Federal Reserve's interest rate hikes caused volatility in emerging market equities in 2023, but markets in Taiwan, Korea, India, Mexico and Brazil performed well while China and most Middle Eastern countries suffered.
- Growth is expected to be softer in 2024 due to "higher for longer" interest rates in the US and geopolitical tensions between the US and China. However, India and Indonesia have shown relative strength, and Latin American and select Eastern European economies are expected to lead the broader emerging markets with respect to rate cuts in the medium term.
- Investors should be aware of the risks associated with China's uncertain economic recovery and possible negative surprises from elections in Taiwan and the US, but there are long-term opportunities in the evolution of EM consumers, de-globalization, artificial intelligence and digital transformation, energy transition, as well as structural changes and reforms in countries like India, Indonesia, and Saudi Arabia.
Equity
Equity
Equity market review 2023
Unsurprisingly, unprecedented interest rate hikes from the US Federal Reserve caused some volatility in emerging market (EM) equities in 2023. The state of the US economy and subsequent implications on inflation and rates, as well as unmet expectations around the recovery in China, were the main macro factors affecting the asset class. EM equities edged higher by more than 10% early in the year, only to lose steam. However, since the end of October the market has climbed again, up approximately 5.7% for the year to the end of November (MSCI EM, FactSet estimates per end of Nov. 23).
At the market level, returns have been heterogenous. Tech-heavy Taiwan and Korea performed well as signs of a cyclical bottoming in certain segments are becoming evident. As a beneficiary of American re-shoring efforts, both India and Mexico have done well thanks to a strengthening manufacturing outlook. Brazil outperformed the broader market due to favorable inflationary dynamics that allowed its first interest rate cut in August. On the negative side, China stood out as its economic recovery has been less forceful than expected, both due to the real estate woes and a lack of significant stimulus. In the Middle East, most countries suffered from tepid oil prices, except Saudi Arabia which continued to see inflows into its capital market.
Activity and opportunities
After a choppy first-quarter start, we took a series of actions that helped our performance for the year. They include:
- We resumed our boots-on-the-ground research in mid-2022, traveling to China, Korea, Taiwan, India, Indonesia, South Africa, Saudi Arabia and Mexico.
- Following two years of a myriad of headwinds for EM markets, including the COVID pandemic, China’s changing regulatory environment, heightened geopolitical tensions and a strong US dollar, the operating environment for many EM companies has changed significantly, especially in China. Going back to the drawing board, we have challenged and thoroughly reviewed our long-term assumptions for most of our investments, and made adjustments where appropriate. We have also enhanced our sector review format to enable a more structured review and comparison of long-term assumptions for companies in a given sector.
- Lastly, we have been doing additional scenario analyses to better evaluate the bottom-up stock selection exposure and risks associated with different outcomes.
Outlook and risks
Overall growth is likely to be softer going into 2024. “Higher for longer” interest rates in the US and geopolitical tensions between the US and China are likely to continue to lead the narrative for the equity market.
For China, we believe that the growth momentum will remain soft in the near term given the lack of a large stimulus and woes in the real estate sector. It is important to note there are some bright spots in India and Indonesia, where domestic demand has shown relative strength. India’s economy has continued to produce robust broad-based momentum supported by cyclical and structural tailwinds, while the macroeconomic environment in Indonesia remains stable given well-supported domestic demand and a healthy commodities trade surplus.
Outside of Asia, the Middle East should benefit from structural reforms despite the current conflict in the region. Latin America and select Eastern European economies – such as Hungary and Poland – are expected to lead the broader emerging markets with respect to rate cuts in the medium term, which could help to maintain the economic momentum.
While not our base case, investors should be aware of the following potentially underappreciated risks:
- China’s pace of economic recovery: as authorities in China continue to focus on incremental easing, the pace of recovery remains uncertain as consumer confidence stays subdued. The risk of China not being able to achieve its GDP growth target remains, and the chance of the economy significantly undershooting the target cannot be ruled out.
- Multiple elections in 2024 could lead to negative surprises. The outcome of Taiwan’s 2024 presidential election could have significant ramifications for US-China relations and regional security. The US presidential election is equally important; a Republican presidency led by Trump is likely to lead to higher uncertainty in geopolitics, including US-China relations.
Still, when we look beyond the relatively short election cycle, we do see a few attractive drivers:
- The evolution of EM consumers: a rising middle class likely to drive higher consumption, premiumization and a shift towards discretionary spending and financial deepening.
- De-globalization and geopolitics: reconfiguration of manufacturing and supply chains/”China Plus One” diversification.
- Artificial intelligence and digital transformation: growing strategic importance of semiconductors with large parts of the value chain in Asia.
- Energy transition: electric vehicle supply chain, from raw materials (e.g. nickel ore) to electric vehicles.
- Structural changes/reforms: better institutions, reforms and macro conditions in countries like India, Indonesia and Saudi Arabia.
With respect to our portfolio, we believe that we can continue to add value for our clients with our active approach for two main reasons. We have identified significant upside to fair value in several areas within our portfolio by using our long-term intrinsic value framework despite the recent rebound in select names. In addition, we are seeing a turnaround and/or thesis validation from the operating metrics in some of the companies that have affected performance in recent years.
Key fixed income insights:
Key fixed income insights:
- Yields on emerging market sovereign and corporate bonds are at decade highs, with the most attractive opportunities in performing high-yield and distressed credit.
- Positive technicals exist given the higher interest rate environment, enhanced multi-lateral support, negative net bond issuance and foreign ownership of EM debt at multi-year lows.
- 60% of the countries in the JPM EMBI Global Diversified Index are net exporters of commodities and benefit from rising demand alongside limited supply.
Fixed Income
Fixed Income
Economic growth
Central banks in emerging markets were ahead of the curve in the interest rate hiking cycle through 2022-2023, with many economies now experiencing disinflation. Controlling inflation continues to be one the drivers of economic growth and stability, and hence some central banks have already started cutting rates. This is supportive of the growth trajectory for emerging markets, and the gap between emerging market (EM) and developed market (DM) growth is expected to continue to widen in favor of emerging markets as shown in Figure 1.
Figure 1: EM-DM growth differential
Growth prospects for certain EM countries such as Mexico, Brazil and Poland are likely to benefit from secular trends with a long runway. Near-shoring and friend-shoring, as well as an increase in foreign direct investments as businesses adjust their global supply chain strategies, are likely to drive this.
Recovery of economic activity in China was muted in 2023 as consumer demand remained subdued and property sector deterioration continued. The slew of policy announcements from Chinese authorities to shore up the housing market and boost consumer confidence should support a reversion to growth in 2024, even though the pace might not be as fast as it has been historically.
Commodity prices
Oil prices spiked to decade highs and broke through the psychological $100 mark following Russia’s invasion of Ukraine in early 2022. Consistent releases from Strategic Petroleum Reserves led by the US caused prices to come back down.
In June 2023 the US stopped liquidating its reserves and prices have rebounded since. Compared to the pre-pandemic era, commodity prices now trade within a higher price range as shown in Figure 2. Prices for commodities such as oil and gas, industrial and precious metals, and agricultural produce are expected to be higher due to supply constraints caused by years of underinvestment as well as demand from decarbonization and climate change.
Figure 2: Elevated commodity prices
Bloomberg Commodities Price Indices (rebased March 2016 = 100)
In 2023, world energy demand continued to scale record highs boosted by strong air travel and increased usage in power generation and industrial activity. Copper demand was robust in several Asian countries, with Indian copper cathode imports nearly tripling on a year-on-year basis.
Following recent geopolitical conflicts in Europe and the Middle East, gold once again proved to be a worthwhile hedge for investment portfolios. World Gold Council data shows central bank demand for gold over 2022-2023 is significantly higher than levels of the past decade. The United Nations Food Price Index spiked over the course of the COVID pandemic and continues to be at multi-year highs across meat, dairy, cereals, vegetable oil and sugar sub-segments.
Almost 60% of the countries in the JPM EMBI Global Diversified Index are net exporters of commodities and should benefit from rising demand alongside limited supply.
Enhanced multilateral backstop
Countries are receiving unprecedented liquidity support from multilateral agencies and lenders. Through the Resilience and Sustainability Trust established in 2023, the International Monetary Fund (IMF) is playing an increasingly important role in helping countries with limited room in their budget to address long-term challenges. The IMF Board approved a proposal to increase members’ quotas proportionally by 50% for a more balanced and objective representation. The quotas, which take effect in 2024, will increase by $314 billion to a total of $941 billion. The proposal will impact the interest paid to the IMF as surcharges depend on the amount and duration that IMF credit has been outstanding. Figure 3 highlights the increased borrowing capacity under the new quotas.
Figure 3: New IMF quotas
Outstanding borrowed from the IMF
The World Bank has proposed new steps to significantly boost its lending capacity. Specifically, it is increasing the guarantees provided by World Bank shareholders, raising hybrid capital from shareholder countries, and lifting the current roadblocks that hinder callable capital. Further, the World Bank is also fundraising for a new International Development Association (IDA) Crisis Facility, which will strengthen its ability to help the poorest countries in challenging times.
Therefore, even in a higher-for-longer environment emerging market sovereigns will be able to refinance at attractive rates. Lack of access to capital markets, a key vulnerability marker, is unlikely to be an issue in 2024.
Fundamentals and valuations
Spreads on EM investment grade (IG) sovereigns now move more in line with US investment grade corporates. The percentage spread widening through the Silicon Valley Bank crisis in early 2023 for US IG was 31%, almost double that of EM IG’s 16% level. Since January 2021, the share of single-A and above ratings has risen more in EM IG than in US IG indices.
As shown in Figure 4, net leverage for emerging markets corporates has gone from 1.4 in 2012, to 2.5 in 2015-2016, driven by idiosyncratic events in Latin America, and settled back at 1.4 at the end of 2022. On the other hand, net leverage for US corporates has increased 44% over the same period ending at 2.6.
EM corporates, especially those rated investment grade, have in general grown revenues and earnings at a faster pace than their developed market peers, and this trend is expected to continue.
Figure 4: Lower leverage for EM corporate debt
Within sovereign and corporate markets, there is higher valuation dispersion, which translates into exciting investment opportunities. While spreads for hard-currency sovereign and corporate investment grade are closer to their 10-year averages, the underlying credit fundamentals and consequently ratings have improved significantly as highlighted below in Figure 5. Our recent papers on EM IG Sovereign Hard-Currency debt and EM Corporates cover this opportunity set in more detail.
Spreads for high yield, on the other hand, still offer considerable value relative to history. We proactively stress-test the investable universe by considering potential downside scenarios such as currency devaluations and funding gaps for frontier sovereigns. In 2024, the risk-reward balance is most compelling in certain distressed credits, which can only be harvested by active investment managers with in-depth experience through the credit cycle.
Figure 5: Upward credit migration for EM IG sovereigns and corporates
Investor perception and valuations remain at abysmally low levels in Asian high yield markets, especially within the stressed and distressed China property sector. Given the recent change in stance from policymakers, there is a much higher probability of a positive surprise in Chinese economic data and consequently for Asian corporate credit markets.
Default rates
Default expectations have come off the elevated levels seen during the 2020-2023 period, dominated by idiosyncratic country defaults, geopolitical events and China property sector as shown in Figure 6. Our 2024 default rate forecast for high-yield corporates within the CEMBI Broad Diversified universe is 3.6% and for sovereigns, within our coverage universe, we do not expect any defaults.
Figure 6: EM HY default rates
Against a backdrop of tighter financial conditions, certain emerging market countries are implementing structural reforms through policies that would have been politically difficult to pursue otherwise. This has boosted their ability to pay down outstanding debt which, coupled with their willingness to pay, has significantly improved their creditworthiness.
For defaulted sovereigns such as Ghana, Sri Lanka and Zambia, restructuring discussions between bond holders and relevant multilateral institutions are progressing well. These countries are expected to emerge from default over the course of 2024.
The flurry of defaults in the China property sector is already in the rearview mirror in our view, with most of the privately owned developers in restructuring and some of them progressing further along the road to recovery. Property sales are not yet off trough levels, but are anticipated to improve with the supportive policy backdrop. Further, demand for housing benefits from the long-term trend of migration to the cities and from the cultural home ownership norms.
Technicals
Bond issuance net of amortizations, coupon payments and corporate actions has been negative for EM sovereigns and corporates over the past few years. New issue forecasts for EM sovereigns and EM corporates are at $47 billion and $244 billion respectively, according to JP Morgan estimates. It is the third consecutive year of below average supply.
Foreign ownership of EM debt, especially emerging markets ex-China local currency debt, is at decade lows. EM local China bond funds continue to see sustained outflows on the back of geopolitical concerns and less attractive valuations. Sustained outflows through 2022 and 2023 imply that investors are under-allocated to this asset class. Flows into EM are expected to improve once investors become convinced that rates in the US have peaked and Chinese stimulus measures are having the intended effects. We believe we are close to that point if it has not happened already.
Average coupon of bonds issued in 2023 has exceeded maturing bonds by 150 bps in high-grade and 210 bps in high yield. It is also the first time since 2001 that both segments have been in positive territory. With debt maturities for sovereigns and corporates staggered over the next few years, higher interest rates should bring a gradual increase in the interest payments. This creates a strong upward bias on coupon income and returns generated from the EM debt.
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