Emerging markets found 2021 a challenging year. Mixed vaccination progress across countries contributed to false starts in exiting the pandemic. Economic reopenings in emerging markets lagged behind those in developed markets.
China was a big concern. Tighter fiscal and monetary policies, the “common prosperity” campaign driving regulatory changes across industries, and a zero Covid-19 approach combined to cool investor sentiment.
Worries over US inflation and the direction of US monetary policy also came to the fore. Big emerging markets such as Brazil, Mexico, Russia and South Korea moved ahead of developed markets in raising interest rates to curb price pressures.
Yet there are several reasons to be positive about emerging markets in 2022. For a start, equity valuations appear to have priced in much caution and indicate attractive long-term value. The fixed-income perspective is also encouraging — real yields in emerging markets exceed those in developed markets. In this regard we are noticing shared optimism on emerging markets among our fixed-income colleagues.
Fiscal and current accounts across emerging markets are also in better shape than before. Institutional reforms over the past few decades have strengthened their economic discipline and resilience against crises. Strong commodity prices recently have been an additional windfall for resource exporters. Sturdier finances potentially rule out a repeat of the severe market stresses that hit emerging markets in previous down cycles.
China’s market valuations appear to be near a floor and should be well supported from here after significant negative news over 2021.
Granted, some near-term headwinds could extend into 2022. We expect China to maintain its zero Covid-19 stance well into the year to safeguard the success of the Winter Olympics and the Chinese Communist Party’s 20th national congress. International travel and other mobility restrictions will limit economic activity. Regulatory uncertainty could also continue. We believe the recent regulatory changes are partly a function of China’s political cycle, which is likely to culminate in the 20th national congress. As the political dust settles regulatory clarity should eventually return, as it has in past political cycles.
On a positive note, China’s authorities have shown that they still have a strong pro-growth agenda and have no intention to choke the private sector with rules. They have the policy tools to stabilise growth and are ready to use them if needed, as we saw with the recent cut in the country’s reserve requirement ratio.
In Brazil valuations have fallen to low levels, creating interesting investment opportunities. Concerns over potential fiscal laxity, rising interest rates and the likelihood of a left-wing resurgence at next year’s general elections have led to the market sell-off. Even then, Brazil’s fundamentals appear healthier than they have since its last recession. More recently, its fiscal and current accounts have improved, with higher oil prices aiding the net oil exporter. The macroeconomic tailwind has also played out at the company level. For example, rationalisation and surging cash flows helped by rising oil prices enabled state-owned oil producer Petrobras to reduce its debt in recent years.
India’s economic activity has rebounded since its second Covid-19 wave. The credit cycle has shown signs of an upturn and major banks have recorded healthy loan growth. The housing cycle has also picked up as a result of better home affordability, along with a recovery in the infrastructure cycle amid the government’s infrastructure push. A robust fiscal and current account picture has accompanied India’s cyclical acceleration.
Across emerging markets positive structural forces remain apparent and are likely to foster fresh investment opportunities. Digitalisation is a key theme. India’s thriving internet economy has attracted capital seeking new areas of growth, especially in light of regulatory flux in China. E-payment, food delivery and other disruptive business models have taken off, prompting even traditional businesses to embrace innovation to counter the competition. In China, industrial digitalisation has gained pace as the economy eyes progress up the value chain. Globally, the continued semiconductor shortage underscores the huge demand for chips coming from technology advancements, and we expect strong earnings for some of the world’s largest semiconductor companies in markets such as Taiwan and South Korea.
Decarbonisation is another trend to watch. Major emerging-market pledges to achieve carbon neutrality are likely to intensify electrification and renewable energy efforts, creating multiyear support for relevant industries. We have seen growth for South Korean electric vehicle battery makers and Chinese solar energy companies accelerate sharply, lifting them to world-leading industry positions in the process.
Certain risks could change our overall outlook for emerging markets, though they are not in our base-case scenario. For instance, a sharp and sudden rise in the US federal funds rate could trigger market volatility. Conversely, a dovish US policy surprise could help emerging markets outperform developed markets. Meanwhile, more dangerous Covid variants could emerge. The market swings that followed the recent discovery of the Omicron variant serve as a reminder of the uncertainties that remain, though indicators so far suggest that the variant’s symptoms could be milder than feared. We are also watching China-Taiwan relations as cross-strait tensions brew.
Of course, all investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies. Investments in emerging markets involve heightened risks related to the same factors.
• Sekhon is CIO at Franklin Templeton Emerging Markets.
Would you like to comment on this article?
Sign up (it's quick and free) or sign in now.
Please read our Comment Policy before commenting.