Investors Should Look at Emerging Markets Again

Many factors now favour emerging markets, especially China and Asia as a whole, according to analysts.

Yan Barcelo 19 January, 2023 | 4:48AM
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Night market in Taipei

Since its bottom in mid-October at 3,577 points, the S&P 500 has gained 6.5% by mid-December. However, over the same period, the Morningstar Emerging Markets Index advanced 10.35%.

Of course, a two-month-long lead a bull market does not make, however, it can be a portent of things to come.

“Investors have largely shunned emerging markets this year, but this beaten-down asset class looks poised for a comeback in 2023,” believes Lisa Shalett, Chief investment officer, Wealth Management, at Morgan Stanley

Philip Petursson, the chief investment strategist at IG Wealth Management, wholeheartedly agrees. In fact, “we’re entering a five-year cycle of outperformance on the part of emerging markets,” he asserts. The main reason, he points out, hinges on “extremely attractive valuations” which, compared to the S&P 500, “are exceptionally cheap and stand at a 50% discount,” he points out.

While most of the U.S. market index stood at 19.5 times trailing 12-month earnings by mid-December, it was only around 11 times for the Morningstar EM index. “Last time we saw such a spread was 20 years ago in 2002, the strategist says, just before emerging markets took a lead ahead of the S&P 500.”

Counter-Cyclical China

Analysts agree on three underlying trends that favour emerging markets. The first is a peak in the strength of the U.S. dollar. “As the dollar potentially weakens, Shalett notes, “EM countries could benefit from the relative appreciation of their own currency. Additionally, commodity exporters, such as countries in Latin America, could see commodity prices strengthening due to greater global demand.” Indeed, since its peak at the end of September, the U.S. DXI index has initiated a sustained retreat that has taken it 8.8% lower by mid-December.

The next trend hinges on China. “For the whole of last year, shares were undervalued (in China’s stock markets) and were trading at a 20% discount to fair value, and the discount was even deeper in beaten down sectors like technology and cyclicals,” says Lorrain Tan, Director of Asia equity research at Morningstar.

The Chinese market stands to be moved by “a more pro-growth, stimulus-oriented stance,” Shalett writes, a perception Tan confirms. To begin with, Tan notes, relaxed Covid policies had a direct impact on markets, “and that’s without factoring in policies to boost consumption. We expect more, and there have already been more.”

Furthermore, Shalett and Tan both point to China’s counter-cyclical stance. While all countries in the West are experiencing inflation and monetary tightening, “China has been decoupling, Tan points out. Inflation is not an issue and interest rates are not rising.” Compared to the rest of the world, “China is in a different cycle,” she says, while Shalett adds: “This is giving Beijing significant runway for stimulus.”

China is set to pull emerging markets ahead as a whole. “If we do see a reopening of China, earnings growth of emerging markets could be superior to those in the U.S., Petursson claims.

If you look at emerging markets as one single economy, centred mostly around Asia, while the U.S. is moving toward recession, China is emerging from lockdowns and will resume its economic growth.”

Asia as a Separate Economic Block

The third trend is Asia centered around China. “It’s fair to say that it is a separate economic block,” Petursson says, and it is demonstrating areas of dynamism that contrast sharply from what we see in the West. The strategist points, for example, to Indonesia’s many young consumers and labour, which China is trying to benefit from through its One Belt One Road initiative. “In order to tap efficiently into such markets, China needs to get its products out there. I think they will be successful with it.”

Shalett shares Petursson’s view. “We also expect China to continue to court economic integration with some of those same countries, extending efforts first nurtured through its Belt and Road infrastructure program.” However, she extends the vista beyond China. “The reorganization of strategic supply chains could create new opportunities for EM nations other than China. In areas such as consumer and industrial goods, we anticipate new relationships between the U.S. and India, Latin America and non-China-linked countries in Southeast Asia. (…) Investors should consider rebalancing EM exposure with an eye toward China onshore companies, as well as opportunities in South Korea, Taiwan and Brazil.”

However, Petursson warns against being focused on countries rather than companies. “The solidity of countries is not as important as that of individual companies.” Also, he advises: “It’s better to look at emerging markets as a broad category, rather than to look at individual countries. The goal is to diversify, and remember that it’s an area where active management can outperform.”

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About Author

Yan Barcelo  is a veteran financial and economic journalist with more than 30 years of experience, Yan writes for many publications in Toronto and in Montreal, including CPA MagazineLes Affaires and Commerce.

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