Are the Stars Aligning for Emerging Markets?

Written by: Gabriela Santos

2022 was not kind to emerging market (EM) equities, with a negative return of -20% in U.S. dollars and an underperformance of 250 basis points (bps) versus the U.S. Looking forward, the very same factors that weighed on EM performance last year are now turning positive this year, namely the shifts from: rising to easing EM inflation, appreciating to depreciating U.S. dollar and decelerating to accelerating Chinese growth. As previously argued, the pendulum shift in China’s economy is a powerful positive catalyst for Chinese – and broader EM - economic and earnings growth. While uncertainty remains about the cyclical path of U.S. policy and growth, the picture has gotten much clearer (and more positive) in China since late 2022. The macroeconomic stars do seem to be aligning for EM going forward. February’s -7% pull-back, following October to January’s strong 22% rally, gives investors another opportunity to ensure they have enough exposure to the asset class at still discounted valuations.

We believe a combination of factors do suggest the stars are aligning for EM equities:

  1. Easing EM inflation has given room to EM central bankers, who were pre-emptive in raising rates versus the Federal Reserve (Fed), to cut decade-high interest rates; a move which could eventually support domestic growth.
  2. U.S. dollar peaking in late 2022, after touching its highest levels since the 1980s, and subsequent depreciation bodes well – EM equities typically outperform when the USD is not rising. Peak interest rate differentials and shrinking growth differentials between the U.S. and the rest of the world, combined with better risk appetite for overseas equities, suggest the weaker U.S. dollar trend has more support.
  3. Accelerating Chinese growth due to its reopening post stringent covid lockdowns and softening of the governments’ tough regulatory stance should lift its economy, given 55% of its gross domestic product (GDP) is consumption. This is likely also a boost to other Asian nations dependent on exports to and tourists from China. In fact, after significant downgrades in 2022, the earnings outlook for EM is more positive than other regions in 2023, with upside likely in some sectors and countries due to China’s reopening. The country’s household savings are far greater than they’ve been in several decades suggesting that pent-up spending could boost the economy as mobility increases.
  4. Discounted valuations offer an attractive entry point for investors to increase their exposure, with the price-to-book (P/B) ratio at 1.59x, below the long-term average of 1.80x. Valuation dispersion at the individual country level is wide, with some markets trading at extreme valuations. For example, China is trading at remarkably low P/B ratios relative to its own history, while India is near all-time highs. Market dislocations such as this highlight the importance of experience and active management in EM.

EM earnings expectations downgrades are subsiding

Next 12 months' earnings-per-share consensus, USD

MI_OTMI_3.8.23 Chart

Source: IBES, S&P 500, FactSet, J.P. Morgan Asset Management. U.S. is S&P 500, Europe is MSCI Europe, EM is MSCI EM. Estimates indexed to 100 in January 2020. Data as of February 28, 2023.

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