If there’s been an asset class that’s tried advisors’ and clients’ patience, and for a long while at that, it’s emerging markets equities.
Darlings through much of the earlier stages of this century, developing world equities, broadly speaking, seemingly haven’t regained luster lost during the global financial crisis. That despite tailwinds such as expected GDP increases and several years in which commodities prices surged. During that span, it was significantly more profitable and safer to simply allocate to domestic stocks.
While the sample size is small, emerging markets stocks are showing signs of life to start 2023 as the MSCI Emerging Markets Index is higher by 8.44%. Again, that’s a small sample size, but the performance of that gauge could signal that market participants are wagering that the Federal Reserve will, at some point this year, pump the brakes on rate hikes.
For advisors, another point to ponder this year vis a vis emerging stocks is that developed market central banks, including the Federal Reserve, might fail engineering desired soft landings. In other words, some major developed markets could slip into recessions, leaving emerging economies as the engines of global growth this year.
Speaking of Central Banks…
Experienced advisors know that inflation is often a concern in developing economies and that was the case in recent years. However, emerging markets central banks were more proactive in raising rates to fight inflation. As such, they might be able to lower rates this year in an effort to support economic growth.
“Emerging markets (EM) have weathered rapid rate hikes in developed markets (DM). Central banks were ahead of DM peers in tightening, and high commodity prices helped EM producers. We see the backdrop for EM assets turning more positive as EM rates peak, DM central banks pause, the U.S. dollar weakens and China reopens. By contrast, the damage of higher rates has yet to fully materialize in DM,” according to BlackRock.
Obviously, interest rates affect bonds, too. For risk-tolerant, income-hungry clients, the possibility of emerging markets central banks lowering rates and the U.S. dollar declining could be an efficacious combination for local currency bonds.
“Given its yield and risk profile, an EM debt allocation may present investors with diversification and total return opportunities in today’s market. A weaker dollar could be a net positive for EM local debt; in months when EM currencies rallied, EM local debt’s return was positive 85% of the time with an average monthly gain of +2.29%,” notes State Street Global Advisors.
EM Heft Matters
When it comes to domestic assets, clients are often led to believe concentration risk is an issue to consider and it is, but at the geographic level, it can be advantageous with emerging markets stocks.
That is to say many of the financially flimsiest developing economies account for low percentages of standard emerging markets benchmarks while higher quality Chinese, South Korean and Taiwanese equities command large weights. That could work in clients’ favor this year.
“We see a more positive EM backdrop as DM central banks pause, the dollar weakens and China reopens,” concludes BlackRock. “We take a selective approach across EM – with a wide range of factors at play, from external balances to idiosyncratic sovereign risk. We prefer EM over DM stocks – we think more damage is in the price from earlier hiking cycles.”