By: Manraj Sekhon
Emerging market (EM) equities may have an asymmetric return profile in 2023. Possible incremental negative news related to known factors (e.g., inflation, war, and Chinese growth) will likely have a limited negative effect on markets, whereas positive news could lead to significant gains.
Drivers we have identified as possible catalysts for a recovery in 2023 include:
1) Peaking inflation data in the US and a weaker US dollar.
2) Known recession risks in the US and European Union (EU).
3) An inflection point for Chinese growth and its Zero-COVID policies.
4) Greater resilience in EMs, providing uncorrelated growth opportunities.
Peaking inflation in the US
After a significant increase in US inflation in 2022, consensus expectations are for an equally significant decrease in 2023. This decline will likely be driven by a high base effect, an easing of supply chain bottlenecks and the negative effect on growth from higher interest rates. With the peak in inflation behind us, investors can focus on the implications of a change in the pace of US Federal Reserve rate hikes. These include a weaker US dollar and a reduction in the equity risk premium, both of which are positive for EM. The possibility of a weaker US dollar in 2023 is likely to be accompanied by a recovery in EM fund flows, as investors turn to higher growth markets.
Also Read: US CPI calculation to change for January inflation data
The recession risk in the US and EU in 2023 contrast with EM growth trends. Growth in China is expected to accelerate in 2023, supported by the recent changes in COVID-19 policies whilst growth in India is forecast to be the highest amongst EM and DM countries, continuing from its strong performance trend in 2022. The picture emerging is one where EM growth remains relatively resilient; Asia takes over as a driver of growth at a time when the Middle East and Latin America are moderating.
China reaches a policy inflection point
China’s inflection point began with the easing of access to credit for the real estate sector in October. This was followed by a significant re-set in US China relations at the G20 meeting in Bali between President Xi Jinping and President Joe Biden in November, which has materially lowered the tension between the two countries. The final catalyst is a shift in China’s stance towards managing COVID-19, which followed the successful conclusion to the 20th National Congress.
The leadership in China has belatedly recognised that the bigger risk it faces is no longer COVID-19, but the growth imperative. Therefore, it is making a major pivot in its priorities—moving away from trying to suppress COVID-19, to a policy of living with the virus. Party leaders are now refocusing their efforts on boosting growth and consumer confidence. This transition is critical given poor economic data and weak consumer confidence which culminated in the recent unrest over the uneven application of its Zero-COVID policies.
China’s exit from its virus suppression policies will not be linear and we should expect some reversals. A rise in fatalities and strains on its underdeveloped hospital system are amongst the biggest risks it will face. This is similar to what was witnessed in other regions when they exited lockdowns. For markets, the pivot is the most important development. Investors are likely to look through policy reversals to the real economic impact of reopening. The performance of other markets post-reopening provides a template for investors.
Resilient EM performance trends
The resilience of EMs in the face of significant US dollar strength in 2022 is reflected in the positive relative performance of individual markets, which can be seen in the table below. These uncorrelated performance trends reflect prior economic reforms and a higher share of domestic demand in India and Indonesia. In the case of Brazil, solid fundamentals and an early mover advantage on raising interest rates enabled the market to outperform the MSCI World Index and the local currency to post gains against the trade-weighted US dollar.
Whilst China was severely impacted by its Zero-COVID policies, South Korea and Taiwan—both of which are heavily dependent on global trade—were hit by a slowdown in demand for semiconductors.
These uncorrelated returns reinforce the need to look at EMs individually as opposed to grouping them together. Looking ahead, we expect 2023 to be favourable to EMs, reflecting their economic resilience, and robust domestic demand. In China we expect a release of pent-up demand as it pivots away from its Zero-COVID strategy to one focused on growth.
(Author is Chief Investment Officer, Franklin Templeton Emerging Markets Equities)