Emerging markets: less risk on the road to equities

Vladimir Zakharov

By Sammy Suzuki, CFA; Henry S. Mallari-D’Auria, CFA; & Sergei Davalchenko

Emerging market (EM) equities have been overlooked by many investors as a flurry of macroeconomic and geopolitical threats have drawn attention to risks. Yet these concerns may mask the potential improvements in economic growth and earnings that could provide good reason to redirect capital into developing country equities.

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

Uncertainty and volatility do not go away. Yet, we believe emerging market equities are well positioned to continue to outperform their emerging market counterparts and reverse a long trend of underperformance for three main reasons:

1. Improving economic growth should support business fundamentals

In DM countries, the outlook for recession is high, 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 boost from the reopening of economies will offset the drag from tighter financial conditions and, in our view, should help to widen the growth gap between emerging and developed market economies next year (Display).

Watch out for the gap: EM-DM growth divergence set to widen in 2023

Two lines plot 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 Forecast for 2022 and 2023 Also Excludes Russia As of June 30, 2022 (Haver Analytics and AllianceBernstein)

China is a perfect example. After months of severe closures, the likely reduction in COVID-related restrictions, as well as 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 strengthen its recovery potential. Many developed and emerging countries have embarked on more restrictive monetary policies to fight inflation. Still, we think China, with lower inflation, has room to ease monetary conditions.

In our view, emerging countries are well placed to grow in the medium to long term. Many stand to benefit from avoiding ultra-loose monetary policies over the past decade. Debt levels are generally lower, population growth is more robust than in most developed countries, and productivity continues to improve, reinforcing the favorable fundamental environment for emerging market businesses.

2. Inflationary forces may be less persistent

High global inflation has different effects in different regions. Emerging countries may be better shielded from some of the impact of commodity shocks, supply chain disruptions and post-COVID demand recovery.

This may seem counter-intuitive. But in developed markets, the inflation problem seems more acute and probably more durable. For example, core inflation in the United States – excluding food and energy – is contributing three times more to headline inflation than 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 for emerging markets (Display). Indeed, in emerging countries, food and energy contribute more to inflation, given their significant weight in the CPI basket. It also means that when food and commodity prices stabilize and fall, inflation rates in emerging markets should fall faster than in developed countries.

Another Inflation Story

Pressures could ease sooner and appear in the market

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

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

Additionally, central banks in emerging markets have been more proactive in raising interest rates compared to their counterparts in developed markets. And central banks in emerging markets have generally not implemented quantitative easing during the pandemic, which should help prevent inflation expectations from taking root.

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

Of course, there are real risks to consider. Food price inflation threatens to fuel social unrest in some small emerging countries. The war in Ukraine continues. Sino-US tensions persist, although discussions are underway to resolve issues with Chinese securities listed on US markets. And some countries like Turkey and Argentina face significant challenges.

But overall, most major emerging countries are in a relatively strong position to face the challenges ahead in the coming months, given strong fundamentals. External financing needs are lower, foreign exchange reserves are stronger, emerging market exchange rates are competitive, and rate hikes by emerging market central banks have widened nominal and real interest rate differentials with the United States. As a result, real returns in emerging markets 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 have been under-allocated to equities in recent years.

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

After a lost decade, emerging equity valuations are now very attractive relative to developed markets (Display). 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 a lost decade

The bar chart illustrates the range of price/earnings valuations since 2000 in emerging markets, developed markets and the United States.  The line chart shows earnings estimates for EM and DM stocks since 2012.

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

The earnings cycle of emerging companies is markedly different from that of the United States and other developed countries. U.S. equity markets have benefited from stronger earnings growth over the past decade, but earnings are widely expected to come into question if the economy slows and inflation weighs on margins . By contrast, many emerging market companies have yet to reach their profit potential in certain sectors, including domestic cyclicals and banking. We expect that the acceleration in turnover will support an expansion of profit margins in emerging countries, while in the DM regions, profitability levels are already high.

Capturing this return potential requires a selective approach and rigorous risk management. By identifying companies with strong 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 selection, portfolios can be created that give investors the confidence to increase exposure to emerging market stocks, even in a highly volatile world.

The opinions expressed herein do not constitute research, investment advice or trading recommendations and do not necessarily represent the opinions 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 disclaims all liability with respect to the MSCI data contained herein. MSCI data may no longer be redistributed or used as the basis for any other indices or any other securities or financial products. This report is not endorsed, reviewed or produced by MSCI.

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