January 26, 2023 10:08 am ETVWO, EMME, IEMG, INDA, INDL, INDIA, EPI, SCHE, EDC, EDZ, EMF, SPEM, ADRE, EUM, XSOE, EEV, ESGE, EET, FRDM, FM, FEM, HEEM, DBEM, MFEM, LDM, AVEM, RFEM, ROAM, EJUL, ISEM, JEMA, EMFM, DIEM, CN, FXI, PGJ, EWH, EWT, GXC, FCA, KBA, CHB, CHIQ, CHII, CQQQ, CHIX, CHIE, CHIM, ECNS, MCHI, CXSE, KFYP, KWEB, ASHR, ASH, CNXT, AFTY, ASHX, CNYA, KRN, FLHK, FLCH, FLTW, KURE, KALL, CHNA, ELEGANT, CHIK, CHIH, CHIU, CHIS, CHIR, BABY, GLCN, KESG, KSTR, KFVG, KEJI, RAIC, KTEC, KBUY, TDF, YINN, YANG, FXP, XPP, YXI, CBON, KBND, PIN, INCO, SMIN, NFTY, FLIN, IXSE, GLIN, INDF, IIF, EWZ, BRF, FBZ, EWZS, FLBR, BRZU, BZQ, EWW, FLMX, IDX, EIDO, VNM, VNAM
Summary
- In the past, one of the main attractions of emerging market stocks was a stronger macroeconomic growth environment than that of developed countries.
- We are also seeing signs of falling inflation in several emerging countries, including India and Brazil.
- Investors are understandably concerned about emerging market stocks after several difficult years.
tum3123
By Sammy Suzuki, CFA, Sergey Davalchenko and Stuart Rae
It's been a long and arduous struggle for emerging market (EM) stocks. Since peaking in late 2010, emerging market stocks have underperformed developed stocks worldwide amid a confluence of market and macroeconomic headwinds. Now, a regime shift occurring in global markets may actually help improve conditions for stocks in beleaguered developing countries.
There's a breath of hope in the air for China and emerging markets. Several problematic trends that have dogged emerging market stocks for more than a decade may be easing. Some headwinds may even turn into tailwinds for 2023 and beyond. And with valuations and earnings forecasts now significantly lower, it seems time to take a fresh look at the developing world. Indeed, since the November 1, 2022, low, emerging markets and Chinese stocks, which have weighed on the emerging market index for the past two years, have begun to outperform. Can this recovery be sustained? We think so, for the following reasons:
The economic growth gap is expected to widen
In the past, one of the main attractions of emerging market equities was a stronger macroeconomic growth environment than that of developed countries. However, this growth differential has steadily narrowed (Display) as many emerging market countries overcame the hangover created by China's explosive growth in the early 2000s. Emerging market currencies subsequently adjusted downward, companies reduced leverage on their balance sheets, and commodity prices fell over the next decade, all of which helped to limit emerging market equity returns. These factors have been exacerbated in recent quarters, as emerging economies faced a rapid tightening of financial conditions as most central banks raised interest rates to reverse years of monetary easing. With these adjustments largely realized, productivity gains and favorable demographics could reassert their influence as traditional accelerators of macroeconomic growth in emerging markets.
Emerging Market Economies: Stronger Growth Could Support Equity Markets
IMF and AllianceBernstein (AB)
Historical analysis and forecasts do not guarantee future results.
Based on International Monetary Fund (IMF) data through October 11, 2022, and AllianceBernstein growth forecasts for 2022 and 2023. As of January 1, 2023.
Several forces could begin to shift growth dynamics this year. As growth in developed markets (DMs) slows, economic growth is expected to remain robust in emerging markets, supported in part by China's reopening drive. Since the 20th Communist Party Congress in October, the government has rapidly reopened the economy and reaffirmed its focus on prioritizing growth. Consumer confidence is poised to recover as COVID restrictions ease. Meanwhile, record savings levels are expected to boost consumer spending.
Taken together, these moves could re-energize China's GDP growth, providing a boost to earnings and stock market performance, in our view.
We're also seeing signs of falling inflation in several emerging market countries, including India and Brazil. As inflation slows and the U.S. Federal Reserve nears the end of its tightening cycle, some emerging market central banks may gain confidence to suspend or reverse their own tightening cycles, which have weighed on economic growth over the past two years.
Some emerging market economies will benefit from supply chain reconfigurations. Many companies are diversifying their supply chains away from China, shifting production to countries from Mexico to India, and from Indonesia to Vietnam. For example, Indonesia has seen growing interest from global auto and auto parts manufacturers, attracted by the country's vast natural resources and its ability to supply key inputs for electric vehicles, such as nickel and copper. Vietnam and Mexico benefit from their proximity to China and the United States, respectively, and from existing supply chain networks.
On the margins: profitability differential ready to converge
Low profit growth has weighed on emerging companies over the past decade. The gap between US and emerging market profitability has been particularly wide since the onset of COVID, amid the dominance of US mega-caps and rising prices outpacing costs.
While American companies have a strong track record of innovation and reinvention, the obstacles to achieving exceptional profitability are likely to be greater than in the past. Weaker U.S. economic growth, regulatory pressure on Big Tech, and high labor costs could reduce U.S. margins and help emerging market companies close the profitability gap.
Currency is important for countries and companies
Emerging markets are often vulnerable to currency fluctuations. In recent years, the strong US dollar has created several challenges. It has made dollar-denominated prices less competitive and impacted the financing environment for emerging market countries and companies dealing with external balances.
The US dollar appears to have peaked in September after appreciating for several years. If this trend continues, emerging market equities could enjoy a currency-driven boost. This is because there has historically been a strong correlation between foreign portfolio flows into emerging markets and the US dollar. If improving growth outside the US helps moderate the US dollar's trajectory, we would expect portfolio flows into emerging market equities to increase.
Weaker dollar should support renewed flows to emerging funds
Bloomberg, Haver Analytics, Institute of International Finance and AB
Past performance does not guarantee future results.
The liquid portfolio flows through the end of the third quarter of 2022. The US dollar index is the DXY index, which measures the dollar against a basket of six currencies. Through December 31, 2022
Valuations and Earnings Expectations: A Solid Starting Point
Investors are understandably concerned about emerging market equities after several difficult years. Overcoming uncertainty requires answering a key question: what is priced into current valuations and what is not. Earnings expectations have fallen by about 16% from their 2022 peak. In contrast, earnings expectations have not fallen significantly in many global emerging market sectors. With the macroeconomic backdrop even more favorable for emerging markets, we expect earnings growth to accelerate further. Meanwhile, emerging market equity valuations appear attractive relative to their history and developed markets (Display). With lower valuations, we believe investors can benefit from further upside potential if headwinds continue to ease and potentially even turn into tailwinds. We see “value” in growth stocks after the major downgrade. However, we believe attractive opportunities can be found across the market, including in value and low-volatility stocks.
What are the pricing of emerging market equity valuations?
Fact set and AB
Historical analysis and forecasts do not guarantee future results.
On December 31, 2022
Truth be told, the road ahead will not be smooth. Geopolitical tensions and trade war concerns may resurface as the world's two largest economies collide, while economies and companies are busy recalibrating their supply chains. Similarly, while emerging market economies appear healthier than in the previous tantrum, politics and populism may impede fiscal consolidation and thus bring volatility. Therefore, even in the most favorable conditions, we believe a highly selective and active investment approach is essential to identify emerging market companies with solid business fundamentals and long-term return potential. Different approaches will suit different risk-reward appetites and long-term goals. Identifying the right approach now is the first step to positioning yourself to participate in the emerging market equity recovery potential that may be unlocked in the coming years.
The opinions expressed here do not constitute research, investment advice, or trading recommendations, and do not necessarily represent the views of all AB portfolio management teams. Views are subject to change over time.
MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to the MSCI data contained herein.
MSCI data may not be redistributed or used as the basis for any other equity index or financial product. This report is not endorsed, reviewed, or produced by MSCI.
Editor's note: The summary points in this article were chosen by Seeking Alpha editors.
This article was written by
AB is a research-driven investment firm that combines investment expertise and innovative thinking to deliver results for our clients. At AB, we believe that research excellence is key to better results, and as a result, we have built a global firm with outstanding research capabilities. We offer a broad range of investment services spanning geographies and asset classes to meet the needs of individual clients, mutual fund investors, and institutional clients worldwide.
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