Interview, Fireside Chat
Is it time to invest in emerging markets?
- Key Thesis: Despite steep losses in 2022, the quality of emerging market (EM) earnings is expected to be significantly higher in 2023 due to cyclical improvements and structural shifts.
- Headline EM corporate earnings growth for 2023 is projected to be tepid, with a potential low-to-mid single-digit decline driven by a high base in commodity and energy sectors.
- Structural growth sectors (consumer staples, discretionary, financials, healthcare) are forecast to deliver double-digit earnings growth.
- China Reopening Dynamics:
- China's economy has reopened as of December 2022, with a pace of recovery exceeding initial investor expectations.
- The government has signaled a policy pivot toward the real estate sector and a renewed welcome for the private sector.
- Reopening is viewed as a positive margin driver for EMs via three channels: increased imports for exporters (Asia, Latin America), growth in tourism services, and higher commodity demand (benefiting Brazil, South Africa, Chile, Peru).
- Outlook calibrates expectations to mid-single digit growth (5%–5.5%) rather than a dramatic expansion; it is not expected to be the sole driver of EM returns.
- India Performance and Outlook:
- India equities outperformed the broader MSCI EM index by over 50% cumulatively in 2021–2022.
- Drivers include 7% real GDP growth in the prior year, labor law reforms, production-linked incentives for manufacturing, and the privatization of Air India.
- Goldman Sachs forecasts India to achieve 16%–18% corporate earnings growth in 2023.
- Valuations are noted as expensive compared to historical averages but justified by visibility of 6%–7% real GDP growth over the next decade.
- Debt and Macro Environment:
- U.S. rate hikes are currently driven by stronger U.S. economic activity rather than global inflationary fears, a distinction that supports EM resilience.
- EM sovereign debt dynamics have been relatively stable; interest payments as a percentage of GDP have increased only 0.3% since 2019.
- Many EM borrowers are now funded in local currency, reducing sensitivity to dollar fluctuations and negative real rates.
- EM central banks largely peaked on rate hikes in the second half of 2022, and fiscal tightening is ongoing in most nations, suggesting liquidity conditions may have reached a cycle low.
- Geographic Differentiation and Resilience:
- Resilient Markets: Mexico and Indonesia are highlighted for strong fundamentals, with Mexico benefiting from proximity to the U.S., remittances, and supply chain pivots away from China.
- Vulnerable Markets: Countries with weak fiscal discipline, such as Ghana, Sri Lanka, and Zambia, face continued pressure and debt restructuring.
- Semiconductor Cycle: The cycle is showing early signs of bottoming out, with inventory destocking stabilizing, providing a silver lining for equity markets previously hit by tech drawdowns.
- Specific Sector Risks: Korea and Taiwan are expected to see earnings declines in H1 2023 due to lingering inventory distortion cycles.
- Valuations and Liquidity:
- EM Equities: Trading at a 11.5x forward P/E (in line with long-term average) and a 1.6x forward Price-to-Book (below the 1.8x long-term average).
- Discount to U.S.: EM equities currently trade at a 35% discount to the U.S. market, exceeding the 25%–30% long-term average, indicating potential for multiple expansion.
- Liquidity Conditions: After significant outflows in 2022, markets saw a reversal early in 2023, with $50 billion in issuance in the first two months (approx. 50% of annual requirement).
- Differentiation: Liquidity access is now highly differentiated, favoring borrowers with improved solvency and fundamentals over those that have not tightened fiscal policies.
- Debt Restructuring Risks:
- Debt negotiations for distressed nations (e.g., Zambia) are complicated by China's growing role as a bilateral lender that often negotiates separately, potentially slowing resolution.
- Extended negotiations negatively impact both bondholders (lower recovery rates) and borrower nations (reduced market access and essential spending).
- Investment Strategy and Recommendations:
- Equities: Focus on bottom-up selection of businesses with strong competitive advantages and quality management, specifically in consumer, financials, and IT sectors (e.g., retail banking, e-commerce, health insurance).
- Debt: Constructive on EM corporate debt, particularly investment-grade (IG) bonds, which offer yield pick-ups over developed market counterparts and access to Asian growth.
- Sovereigns: Prefer high-quality sovereigns (e.g., Indonesia, Mexico) that have maintained sensible economic policies.
- Long-term Themes: Opportunities exist in the energy transition, digitization, and infrastructure development within EMs.