Russia’s invasion of Ukraine has worsened inflationary pressures and the global economic outlook. The war has created a commodity supply shock, which will negatively affect global demand and cause margin pressure for many companies. Aggressive sanctions imposed on Russia have also caused ongoing asset write-downs, for investors and banks.
All these changes will reduce global growth. However, the overall backdrop is not necessarily negative for emerging market (EM) equities. Indeed, we think there are four key factors that should help to support performance going forward.
1. EM interest-rate cycle versus US interest-rate cycle
With oil and other commodity prices jumping due to the Ukraine war, already high inflation has surged even higher, strengthening the US Federal Reserve’s (Fed) resolve to combat inflation. Indeed, the Fed has already implemented the first of a total of seven expected rate hikes in 2022. In the past, such conditions have often not boded well for EM assets – partly because higher US interest rates have tended to push up EM interest rates too, thereby curtailing growth.
However, this time the situation is rather different. Firstly, many EM central banks have been more proactive and have already been raising interest rates well ahead of the Fed. As such, while the timings of rate cuts have probably been pushed out by the Ukraine war (due to higher inflation), for many EMs, the need to keep pace with the Fed should be reduced. Secondly, many EMs appear much better placed to weather Fed rate hikes than in the past, thanks to healthier external balances.
2. Countercyclical policy support in China
The present economic situation in China is quite different to the rest of the world. The growth outlook is challenged by the ongoing property sector downturn and a strict ‘zero-covid’ policy that is resulting in economically damaging lockdowns in major cities like Shanghai and Shenzhen. However, with inflation running at close to 1%, in marked contrast to most other regions, China has significant scope to support the economy through both monetary and fiscal policy. Indeed, since December of last year, the Chinese central bank has already cut its prime one-year loan rate on two occasions.
“…in marked contrast to most other regions, China has significant scope to support the economy through both monetary and fiscal policy…”
Going forward, additional risks stemming from the Ukraine war have reinforced the case for continued proactive Chinese policy support. Expectations that the regulatory backlash, which has weighed greatly on the country’s tech sector, would lessen were reinforced when Chinese Vice-Premier Liu He recently urged regulators to adopt a more ‘standardised, transparent and predictable’ approach.
Meanwhile on the domestic politics front, it’s worth noting that the Chinese Communist Party’s 20th Party Congress is due in the fourth quarter. In this important event, when President Xi Jinping is widely expected to be confirmed for a third term as party leader, the need for evidencing economic stability and tangible progress towards China’s official 2022 growth target of 5.5% will be paramount.
All these factors support the case for China equities (which have a nearly 32% weighting in the MSCI EM Index) being on a much surer footing in the latter part of the year.
3. Rising commodity prices supportive for some EMs
The breadth and scale of the commodity supply shock and surging inflation is clearly negative for global growth as a whole. Yet it’s worth noting that structurally higher commodity prices represent a transfer of wealth from consumer countries to producer countries, many of which are EMs. For example, strong commodity prices tend to be beneficial for many Latin American economies, but have a net negative impact on most Asian economies, which for the most part are consumers.
For active investors, these kinds of differential impacts can be valuable sources of outperformance compared to indices. Similarly, to the extent that the recent commodity price shock reinforces investment demand for clean energy, an area where many EM companies already have dominant positions, active investors could also look to benefit.
4. Compelling relative valuations
Owing partly to the marked underperformance since 2021, EM equities are now significantly cheaper compared to most other global equity markets. For example, the current forward price-earnings (PE) ratio of the MSCI EM index of 11.7 represents a 33% discount to the broader MSCI World PE ratio of 17.4. The discount is even larger, and closer to 40% when compared to the 19.2 forward PE of the US S&P 500 Index.
The relative cheapness of EM equities is also apparent in a wide range of other key valuation indicators. For example, the MSCI EM index current price-book ratio of 1.80 is 41% lower than the 3.07 for the MSCI World Index, while the MSCI EM index current dividend yield of 2.55% is also well above the 1.87% for MSCI World Index. (1)
MSCI EM Index PE ratio versus MSCI World Index
Source: Bloomberg, CLSA March 2022
A key driver of the sell-off in EM equities in the past year has been the pronounced weakness in Chinese equities. This reflects the aforementioned economic factors, as well as some more market-related factors, such US de-listing fears. Relative valuations in this key part of the EM world have become particularly extreme owing to some quite indiscriminate selling of late. However, while selectivity will be key, given the backdrop of proactive stimulus, less regulatory intervention and a stabilising property market, we think Chinese equities have a good chance of recovering and re-rating, potentially quite significantly in coming quarters.
Putting everything together
Putting everything together, following a period of marked underperformance, EM equities now appear attractively cheap compared to most other markets. We think the case for the value gap narrowing is supported by the comparatively advanced stage of the monetary-tightening cycle in many EMs.
Furthermore, in the key China market, we think the prospect of further policy stimulus, less regulatory intervention and a stabilising property market, could drive a marked recovery in coming quarters. However, in periods of increased volatility, as of late, we think a selective approach that is responsive to changing risks, will remain of paramount importance.
References:
1) MSCI Index factsheets, as of end-February 2022
