Nov 27, 2023
Watch Grant, Victoria and Varun discuss the macro environment, what to keep an eye on in EM equities, and opportunities in fixed income.
With emerging countries much further along in their economic cycles, many EM central banks are already embarked on policy loosening. Monetary policy works with a lag, typically of 12-18 months, so the positive impetus of 2023’s easing could start to be felt in the months ahead. But whenever it materialises, it will likely manifest in the developing world before the US and other advanced economies experience similar effects. As we suggest in our ‘Macro outlook’, the latter may yet have a higher price to pay for the shift into a new interest-rate regime, particularly in terms of growth. On a relative basis at least, emerging markets can head into a new year with some confidence.
At a global level, then, the path immediately ahead could be choppy. But beneath the surface, currents that favour emerging markets are gathering force. We think this is a good time for fixed income and equity investors to review their EM allocations.
Timing turning points is always difficult. But at the start of a new year, there is a reasonable chance that three major headwinds for EM investors could begin to turn into tailwinds.
First, a change in the trajectory of the US dollar would be a significant boon. The strength of the US currency has been a headache for EM equities, EM local-currency bonds and EM economies generally for an extended period (see Figure 1). As the IMF has noted, an appreciating greenback hurts GDP growth in emerging economies much more than advanced ones, and for much longer2. Trying to predict exactly when the US dollar might revert can make a fool of anyone – as the top-callers found in the summer of 2023 when the currency dipped, only to resume its rise. But we can certainly say that the US dollar enters 2024 with a valuation that looks extended.
Figure 1: US dollar real effective exchange rate
Source: Bloomberg, as at 30 September 2023.
After a year of recurrent anxiety about China, stabilisation of the Chinese economy – of which we think there is a fair chance in the next 12 months – would also spur developing economies. Policy tightening to address the imbalances of China’s growth model of the last three decades has had a materially negative impact in the past year, and China is not out of the woods yet. The bigger picture is that the country remains in a multi-year transition to a more domestically driven, higher value-add economy. Its leadership is extremely incentivised to ensure this transition proceeds, which requires adequate nominal growth. We think they are capable of delivering such an outcome and that Chinese domestic consumption growth should level out in 2024.
Finally, for EM fixed income investors in particular, market expectations of gradually slowing global growth, lower inflation and lower interest rates in 2024 would be a strong positive, presenting opportunities to earn the additional carry that these markets offer against a less volatile backdrop.
Current valuations also suggest an attractive entry point. But with risks remaining to global growth, inflation and geopolitics, a flexible, bottom-up approach is vital in a year when some central banks will be cutting rates and others will still need to be hiking, and where some economies will be more resilient than others. As noted earlier, our ‘Macro outlook’ posits that the coming period may be less benign than markets are discounting. Even so, getting through the top of this US interest-rate and inflation cycle should mark a sea-change in bond markets after a brutal period, EM fixed income markets’ outperformance of developed bond markets in 2023 notwithstanding.
Whatever the next 12 months bring, investors can take comfort that the starting point for emerging markets is generally a robust one. Many emerging economies have solid fundamental foundations, partly as their response to COVID was necessarily more fiscally conservative than developed economies. Based on our EM Fixed Income team’s measures of credit vulnerability, fundamentals are at their strongest levels since 2014: fiscal strength is seeing the biggest improvement, with prudent policymaking resulting in increasingly healthy primary fiscal balances across EM economies, and debt-to-GDP stabilising at modest levels. Meanwhile, the more fragile emerging nations are well supported by the International Monetary Fund and other multilaterals. Overall, EM central banks have emerged from the turbulence of the post-COVID years with enhanced credibility, and in many cases developing nations’ fundamentals are in the best shape in years. The same cannot be said of many advanced economies.
Emerging market corporates are also in good shape, with lower leverage relative to comparable developed market businesses, putting them in a robust position to navigate tougher economic environments. They reduced leverage and shored up balance sheets when business was booming, secured cheap finance when rates were low, and are benefiting from that now.
There are clearly risks for EM investors. Not least among them is the potential for the conflicts in Eastern Europe and the Middle East to widen. Meanwhile, the transition to a new equilibrium in the US’ and China’s relative power status has years to run, likely driving higher macro volatility. Amid all of this, Bloomberg3 calculates that some 40% of the world – whether measured by population or GDP – will head to the polls in 2024. Of the 40 scheduled national elections, 17 will be in emerging markets.
Finally, as we suggested, from an economic perspective, expectations for a soft landing and gradual global slowdown may prove wishful thinking. A recession is by no means off the table.
EM countries and regions heading to the polls in 2024 (general, presidential and local elections)
Venezuela’s elections are scheduled for sometime in H2 2024
Source: Ninety One, Bloomberg, Citigroup.
Nevertheless, as we explore throughout 2024 Investments Views, for investors with a moderate horizon we see positive beta and alpha potential in emerging markets, in both equities and fixed income.
We also see excellent opportunities for longer-term investors to build exposure to the structural changes that are unfolding across the developing world, including the transition to a lower-carbon economy.
From a wider perspective still, global economic momentum continues to shift away from advanced western nations as emerging markets constitute a larger share of economic activity. If nothing else, the next 12 months should provide ample opportunities to start thinking how to re-orient portfolios for a changing world in which emerging markets will play an ever greater role.
1Ninety One Investment Institute, ‘In the crossfire: revisiting the investment case for emerging markets’, November 2022.
General Risks. Forecasts are inherently limited and modelling involves risks, assumptions and uncertainties, they are forward looking and are not guarantees nor a reliable indicator of future results. Actual returns could be materially higher or lower than projected. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. The value of investments, and any income generated from them, can fall as well as rise. Costs and charges will reduce the current and future value of investments. Where charges are taken from capital, this may constrain future growth. Past performance is not a reliable indicator of future results. If any currency differs from the investor's home currency, returns may increase or decrease as a result of currency fluctuations. Investment objectives and performance targets are subject to change and may not necessarily be achieved, losses may be made. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.
Specific Risks. Commodity-related investment: Commodity prices can be extremely volatile and significant losses may be made. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise.