Emerging Markets: Less risk on the way to equities

Financial term Emerging market on blue and green financial background from charts, graphs.  3d rendering

Vladimir Zacharov

by Sammy Suzuki, CFA; Henry S. Mallari-D’Auria, CFA; and Sergey Davalchenko

Emerging Markets (EM) equities have been overlooked by many investors as a wave of macroeconomic and geopolitical threats have drawn attention to risks. Yet these concerns can obscure the potential improvements in economic growth and earnings that could provide good reasons to shift capital into developing country equities.

Emerging market equities have done surprisingly well this year. While they fell alongside global equities, the MSCI Emerging Markets Index outperformed the MSCI World Developed Markets (DM) Index in the first half of 2022. Emerging Markets fell 17.6% in dollars USA, while the S&P 500 and the MSCI World Index fell 20.2% and 20.5%, respectively.

Uncertainty and volatility are not going away. However, we believe emerging market stocks are in a good position to continue to outperform their emerging market counterparts and reverse a long pattern of underperformance for three main reasons:

1. Improved economic growth should support business fundamentals

In DM countries, recession prospects loom large as persistent inflation has put pressure on demand. But many emerging economies are still recovering from the COVID-19 pandemic, particularly in Asia, where domestic activity is improving. The thrust of reopening economies will overcome the resistance of tighter financial conditions and, in our view, should help widen the growth gap between emerging market and emerging market economies next year (Screen).

Mind the Gap: Growth Divergence Between Emerging Markets and Emerging Markets Is Ready to Widen in 2023

Two lines trace real GDP growth in emerging and developed markets since 2000, with black bars illustrating the gap between them.

Historical analysis and forecasts do not guarantee future results. Emerging Markets Growth Forecasts for 2022 and 2023 also exclude Russia As of June 30, 2022 (Haver Analytics and AllianceBernstein)

China is a prime example. After months of severe blockages, the likely easing of COVID-related restrictions, coupled with economic stimulus programs, should help stimulate growth in the second half of the year. This, in turn, will increase corporate profits, in our view.

China is also on a different monetary and fiscal policy trajectory which should increase its recovery potential. Many developed and emerging countries have undertaken more restrictive monetary policies to fight inflation. However, we believe China, with lower inflation, has room to ease monetary conditions.

In our opinion, emerging countries are well positioned to grow in the medium and long term. Many should benefit from avoiding ultra-easy monetary policies over the past decade. Levels of indebtedness are generally lower, population growth is more robust than in most developed countries, and productivity continues to improve, adding to the favorable fundamental environment for emerging market companies.

2. Inflationary forces may be less persistent

High global inflation is having different effects in different regions. Emerging countries may be better protected from the impact of commodity shocks, supply chain disruptions, and the resumption of post-COVID demand.

It might seem counterintuitive. But in developed markets, the inflation problem seems more acute and more likely to last. For example, US core inflation excluding food and energy is contributing to core inflation three times its historical average due to aggressive fiscal and monetary responses to the pandemic. In contrast, core CPI is only 1.8 times the historical average in EM (Screen). This is because, in emerging countries, food and energy contribute more to inflation, given its large weight in the CPI basket. This also means that as food and commodity prices stabilize and decline, emerging market inflation rates are expected to fall faster than in the DM countries.

A different story of inflation

The pressures may ease off earlier and appear on the market

Two bar charts illustrate the differences in the composition of core and headline inflation for emerging countries versus the United States.  A line graph shows the inflation differential and nominal yield differential between the EM and DM countries.

Past performance does not guarantee future results. * Core inflation is estimated by removing food and energy (fuel plus electricity / gas) from the main CPI. Constant GBI weights are used. As of 30 June 2022 (Bloomberg, Haver Analytics and UBS)

Additionally, emerging market central banks have been more proactive in raising interest rates than their developed market counterparts. And emerging market central banks generally did not implement quantitative easing during the pandemic, which should help prevent inflation expectations from consolidating.

Meanwhile, while the inflation differential between emerging and developed markets is in line with historical levels, emerging markets offer one of the highest yield spreads compared to average markets over the past decade. This suggests that markets have already priced expectations that inflation will be less persistent in emerging countries to a greater extent than in previous cycles.

Of course, there are real risks to consider. Food price inflation threatens to fuel social unrest in some smaller emerging countries. The war in Ukraine continues. Tensions remain between China and the US, although discussions are underway to resolve issues relating to Chinese stocks listed on US markets. And some countries like Turkey and Argentina face significant challenges.

But overall, most of the large emerging markets are in a relatively strong position to tackle any upcoming challenges in the coming months given the strong fundamentals. External financing needs are lower, foreign exchange reserves are stronger, emerging market exchange rates are competitive, and emerging market central bank rate hikes have pushed up nominal and real interest rate differentials with the United States. Therefore, emerging market real returns are now mostly positive.

Positive real interest rates (bond yields minus the rate of inflation) in several emerging countries, combined with faster economic growth, should, over time, help attract investment flows to emerging markets, where investors in recent years were under-allocated to shares.

3. Emerging market valuations are attractive and corporate earnings should improve

After a lost decade, emerging market equity valuations are now very attractive relative to developed markets (Screen). Further improvements in investor sentiment could pave the way for a recovery, especially if earnings improve.

Ready for recovery? Emerging market valuations look attractive after the lost decade

The bar chart illustrates the range of price / earnings valuations since 2000 in EM, DM and the US.  The line chart shows earnings estimates for emerging market and emerging market equities since 2012.

Past performance does not guarantee future results. EPS: earnings per share Left view as at 30 June 2022; right display as of July 26, 2022 (Bloomberg, FactSet, MSCI, S&P and AB)

The corporate earnings cycle of emerging markets is markedly different from that of the United States and other developed countries. US equity markets have benefited from stronger earnings growth over the past decade, but profits are widely expected to be strained if the economy slows and as inflation weighs on margins. Conversely, many emerging market companies have not yet reached their profit potential in sectors, including domestic cyclical stocks and the banking sector. We anticipate that top-line revenue acceleration will drive profit margin expansion in emerging countries, while profitability levels are already high in DM regions.

Capturing this return potential requires a selective approach and rigorous risk management. By identifying companies with solid fundamentals and resilient business models, investors can find stocks across all sectors that are well positioned to deliver long-term results in a challenging environment. And with a disciplined approach to stock picking, you can create portfolios that give investors the confidence to increase exposure to emerging market equities, even in a very volatile world.

The views expressed herein do not constitute research, investment advice or commercial recommendations and do not necessarily represent the views of all of AB’s portfolio management teams. Views are subject to change over time.

MSCI makes no warranties or representations, express or implied, and will have no liability with respect to the MSCI data contained in this document. MSCI data may not be further redistributed or used as a basis for any other indices or securities or financial products. This report is not approved, reviewed or produced by MSCI.

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Editor’s Note: The summary bullet points for this article were chosen by the editors of Seeking Alpha.

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