Structural Drivers Underlie Emerging Markets' Growth

Rising U.S. interest rates and the stronger dollar are typically negative for emerging markets. Despite faster economic growth, emerging markets have underperformed developed markets again this year. Looking under the hood of the MSCI Emerging Markets (EM) Index, there has been a bifurcation in regional performance year to date. On the positive side, even with currency depreciation, Indonesia returned 6%, India was down by only 5%, and Brazil was up 11%, all in USD terms, through November 25. However, China was down 31%, and Russia’s exit from the MSCI EM Index (roughly 5%) weighed on returns. Excluding China and Russia, emerging markets would have significantly outperformed the U.S., as of November 25. While broader emerging markets have declined mainly due to idiosyncratic risks, they have shown resiliency in terms of growth and currency strength, continue to be positioned well for greater future growth, and are valued at historical lows compared to developed markets.

Emerging markets are in a better place than in the past

India and Indonesia Poised for Further Growth

In India and Indonesia, fiscal stimulus has been more moderate than in developed markets, central banks have been prudent with monetary policy, and inflation is under control. Consumers are under-leveraged and credit growth is improving. Income growth in India’s urban markets is ahead of inflation and the IT sector is performing well. Importantly, both countries’ currencies have held up better than expected, despite sharp US rate rises and USD strength. As US interest rate expectations peak, those currencies may outperform in the next 18 months.

Indian structural reforms, such as the implementation of a goods and services tax, enhanced bankruptcy law, and the clean-up of weaker financial institutions, were important but also headwinds to growth over the last five years. With the benefit of these reforms and a stronger banking system, Indian GDP growth is forecast to be 6-7% in the coming 12 months, while non-performing loans in banks have reduced significantly. Indonesia, similarly, has invested in infrastructure, forced commodity businesses to invest in value-add downstream manufacturing, and is benefiting from offshoring from China, which is helping Southeast Asian countries in general. We expect these growth drivers in India and Indonesia to continue in the medium term.

Brazil Moving in the Right Direction

In Brazil, rising commodity prices have been a tailwind, helping lift projections for GDP growth to 2.5%-3% for this year. The election of leftwing Luiz Inacio Lula da Silva as president occurred with a peaceful transition. Concerns are shifting to fiscal policy and the potential for increased social security payments. However, Brazil’s congress has moved further to the right, meaning any plans are likely to be watered down. Political headlines change daily, and Brazil remains a volatile market, but ultimately it is moving in the right direction.

EM Beneficiaries of Supply Chains Shifting from China

Replicating China’s manufacturing position in other regions is happening but will take time. Vietnam is well-positioned to be a long-term beneficiary, thanks to its young and highly educated workforce, as well as its economy that has geared up for semiconductor and apparel manufacturing. Indonesia and Malaysia have benefited more incrementally. India is increasing its domestic manufacturing through its Product Linked Incentive (PLI) scheme, offering incentives on incremental sales of goods manufactured in India.

Large tech companies looking for semiconductor suppliers are focused on manufacturers with strong competitive advantages, high levels of efficiency, and the ability to produce leading edge technology, favoring Taiwan and China. But industries that rely more on workforce demographics and the lower cost labor found in Indonesia, Vietnam and Mexico can benefit from supply chains moving offshore.

China’s Two Biggest Drags: Property Sector and COVID

China’s crackdown on leverage among property developers has exacerbated the country’s real estate crisis. With a significant number of projects incomplete, the problem is somewhat bigger than reports suggest and there is still concern about leverage in the broader economy. Given relatively moderate government stimulus, it will take a long time to stabilize the property market even after the changes announced at the recent Congress of the Chinese Communist Party. We remain cautious about a recovery in property and banking, as well as basic materials tied into those sectors.

China’s zero-COVID policy, which was harshly implemented this year, should continue in the short term. However, the government’s announcement of 20 measures to ease COVID restrictions has increased expectations that the government will move towards a reopening in 2023. We are more positive on companies that will benefit from a reopening and believe the market will look through future short-term lockdowns.

Significant improvements in margins at companies including Yum China and JD.com, even in the face of ongoing lockdowns, have been underappreciated by the markets. Yum China reported a 400 bps-beat on margins, almost returning to pre-COVID levels, and JD.com reported a 200-bps margin improvement, doubling earnings and beating consensus by 40% in its 3Q earnings. Any improvement in the top line could magnify an earnings recovery in 2023.

China Incentivized to Achieve Net-Zero Emissions Ambitions

Often described as “the workshop of the world,” China has become the world’s largest carbon emitter due to export manufacturing and its own consumption. The country has a natural incentive to improve performance because many of its own coastal cities, where substantial manufacturing and population are based, face increased risk of flooding from climate change. The government aims to maximize carbon emissions by 2030 and reach net zero by 2060 – ten years later than the 2050 date the Intercontinental Panel on Climate Change estimates the greenhouse gas budget (in the atmosphere) will be reached, if global warming is going to be limited to 1.5°C.

China is on the path to electrification with massive rollouts in wind, solar, and nuclear power. The replacement of old coal plants with newer, more efficient ones will also improve its carbon footprint. Other initiatives include carbon trading and development of carbon capture and storage. The costs will be high and the targets challenging, but we believe that China is motivated to achieve its goals; timing rather than inclination seems to be the challenge.

Navigating Emerging Markets in 2023

When investing in emerging markets, bottom-up stock picking selectivity and avoiding risks associated with the benchmark is critical. While EM equities offer a margin of safety in terms of growth and valuation today, a prolonged deep global recession poses clear risks. For one, lower levels of profitability make the EM space more difficult to navigate than U.S. equities. Also, EM companies can be more susceptible to sharp slowdowns in global growth. Despite the challenges, however, this environment offers the opportunity for active managers to construct concentrated portfolios of quality companies that offer exposure to the structural growth opportunities that exist in EM, but at acceptable risk levels, with the potential for a smoother ride over time.