2022 was a year when global equity markets were quite correlated – unfortunately to the downside, but we expect that to change in 2023. Our observations of what is happening on the ground give us confidence that Emerging Market economies can recover sooner than Developed Markets, and that equity valuations in EM could improve in 2023 and beyond.
One of the most important capital market drivers in 2022 has been inflation. A common stereotype is that inflation is a challenge for Emerging Markets but not for Developed Markets. But EM policymakers have learned a lot from the financial crises of the 1980s and 1990s. As a result, they have been pursuing very orthodox and disciplined monetary policy for the last 20 years, including last year when the world re-opened from COVID. This time around, EM central banks are ahead of the curve compared to Developed Markets.
Inflation across the major Emerging Markets has been less volatile and is only modestly elevated compared to historical trends. More importantly, because EM central banks have generally been aggressive at raising interest rates to contain inflation, several EM economies already have positive real rates, and others are not far away. We expect inflation is likely to peak and soften in Emerging Markets sooner than in Developed Markets. This has historically been an attractive set-up for EM.
Another common concern about investing in EM is the risk of depreciating currencies, but many EM currencies have held up better to a rapidly appreciating dollar than their Developed Markets counterparts this year.
Several factors have contributed to this currency resilience. First, Emerging Market countries navigated COVID with much less stimulus than the developed world, which has protected their sovereign balance sheets. Additionally, EM countries have become less reliant on trade with developed economies over the last decade, so they can continue to grow even while demand has softened in Europe and the US.
Valuations declined substantially in 2022 across both EM and DM. But something to keep in mind is that before the US and EU started to pursue zero-interest policies after the Global Financial Crisis, equity valuations around the world used to be close. Over the last decade, Emerging Markets maintained higher interest rates, which led to EM equities trading at a discount. Today, EM equity valuations look attractive relative to local interest rates, historical equity valuation levels, and when compared to Developed Markets – which now need to earn their cost of capital since the days of 0% rates are over.
Politics have also been center stage in Emerging Markets this year. Following China’s 20th Party Congress and President Xi Jinping’s election to an unprecedented third term, we have good visibility into who will be leading the country for the next five years and are starting to get more clarity around regulatory policy and economic goals. For example, China is trying to do the right thing to clean up its property market issues. The government is stimulating demand, by allowing second-home purchases in some markets and subsidizing mortgage rates, while doing its best to provide liquidity to developers that are struggling.
The biggest thing that will drive economic growth is people just getting out to work and playing again, post covid shutdown. I think expectations for China are relatively low valuations, not universally, but more in the H-share market. The offshore part of the Chinese equity market is still very attractive, even though we have seen a bounce off the bottom. Looking out for one or two years the multiples are still very attractive, especially relative to developed markets. We see China as a very interesting opportunity on a medium-term basis.
When we went into the Brazilian election, it was very tight, and the result was by no means a broad mandate for Lula’s left-leaning agenda. What we’ve seen since he’s taken office is a hard left pivot to try to push some more of his populist policies.
I think we had expected the Senate to be more of a check initially than it has been. Longer term, given the right tilt in the Senate, we would expect them to bring the most aggressive parts of Lula’s agenda back into the middle. The opportunity and the reason why we think Brazil could be a great story this year is the fact that valuations are really at multi-decade lows. Even though Brazil was a decent market overall last year, that was primarily driven by the commodity companies and the banks, which benefited from high-interest rates. Meanwhile, the rest of the Brazilian index has really suffered, and valuations are quite compressed. Therefore, we see the medium-term outlook for Brazil as still quite strong.
The Middle East is really a relatively undiscovered area of emerging markets that we believe will become a driving influence over the next decade. I know a lot of people think about the region as just purely tied to oil and oil-related revenue with unsustainable government growth models, which were built on turning oil revenue into subsidies for consumption and government handouts.
However, the governments in the region recognize that is not sustainable. First of all, that oil revenue is not going to be around as long as they might hope. Secondly, they have a lot of people they need to employ, not purely through government handouts.
They are therefore working on new businesses that they can bring to the region. Tourism is a big focus. They are monetizing low-cost energy resources for other industries like wafer manufacturing, for example, both for solar, also for logic semiconductors. They are utilizing their low-cost energy resources to monetize them for higher-value production to create jobs and to bring people to the region to drive that economic growth.
If you look at it today, the Middle East has the energy and the economic resources to make this transition. Europe has lost access to low-cost gas and is looking for other sources where it can relocate some of its manufacturing capacity. This would be a perfect option for the Middle East. We are starting to see that type of relationship develop. For all these reasons, we think that there’s a real sort of fertile investment landscape that’s starting to develop there.
While 2022 was a frustrating year for Emerging Markets equity investors, EM economies are well-positioned to reaccelerate in 2023 and beyond.
Opinion article by Charles Wilson and Josh Rubin, fund manageros of Thornburg Investment Management.
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