As the world progresses through the COVID cycle, emerging markets (EM) have so far been resilient from an economic growth perspective. EM central banks have proven more proactive and now have greater flexibility than their developed market (DM) peers, EM economies are forecasted to grow at a premium, and EM equities are trading at a historic discount to the S&P 500®.

EMs have faster growth without the stimulus overhang

As has been the case for the last several years, investors have flocked to the U.S. market and the U.S. dollar for stability, leaving behind non-U.S. equities. For several decades, the Fed continually refilled the market’s punch bowl with stimulus measures in a benign inflationary environment, and the money supply grew at a pace well exceeding inflation. While this resulted in stable growth, the valuation gap for U.S. equities relative to the rest of the world, particularly emerging markets (EM), has increased to historic levels. As shown in Figure 1, the premium for U.S. over EM equities (based on price-to-earnings ratios) is roughly in line with where it was 20 years ago, prior to the S&P 500’s lost decade and emerging markets’ strong decade of performance.

Figure 1: S&P 500® Premium To MSCI EM Index

Line Chart: S&P 500 Premium to MSCI EM Index, 2002-2022

Past performance is not indicative of future results. Source: FactSet as of August 31, 2022.

We think the past level of monetary support is unlikely to continue in view of higher inflation, which could remain extended given supply-side pressures.

Current conditions suggest emerging markets are set for a potentially brighter next chapter.

1. EM economic growth remains higher than the rest of the world and is projected to continue

As shown in Figure 2, the International Monetary Fund forecasts that 2023 GDP growth for EM and developing economies will be 3.9% versus 1.4% for advanced economies and 2.9% for the global economy.

Figure 2: Growth Projections: World Economic Outlook

  2021 2022 2023
Global Economy 6.1 3.2 2.9
Advanced Economies 5.2 2.5 1.4
Emerging Market & Developing Economies 6.8 3.6 3.9

Source: International Monetary Fund. Updated July 2022.

2. EM central banks have proven more proactive and have greater flexibility than DM peers

In our view, developed country central banks such as the Federal Reserve, European Central Bank, and Bank of England have a sizeable gap to close between current interest rate levels and what is needed to rein in inflationary pressures. Conversely, EM central banks have had more experience proactively managing inflation over the years. Figure 3 illustrates the wider gap between current government rates and inflation for developed markets compared to India, Mexico, China, and Brazil. Thus, EM seems to be on relatively solid ground.

Figure 3: Gap Between Policy Rates and Forecasted Inflation

Bar Chart: Gap between Policy Rates and Forecasted Inflation

Source: Organisation for Economic Co-operation and Development (OECD). Forecasts as of September 16, 2022.

3. The U.S. dollar’s precipitous rise this year has had a greater impact on developed country currencies vs. emerging markets.

Figure 4: USD Surges Against Developed Peers on Fed Hikes

Line Chart: Fed Target Rate, USD trade-weighted Index vs. advanced economies, USD trade-weighted index vs. emerging markets, 11/21 to 8/22

Source: Federal Reserve, Bloomberg. As of August 31, 2022.

Where We See Structural Growth Opportunities in EM

EM equities have shown resilience from an economic growth and currency perspective in 2022. However, earlier this year investors were saddled with Russia’s abrupt -100% return and exodus from the MSCI EM Index in just a few weeks after the Ukraine invasion and crippling economic sanctions on Russia. EM investors who did not have exposure to Russia (ourselves included) were able to minimize this risk.

China’s ongoing COVID-related shutdowns and continued property market weakness have also been a headwind. We believe investors should be selective around their positioning in China, seeking relatively lower exposure than the benchmark and avoiding cyclical and lower-quality areas such as financials, energy, materials, and real estate, which comprise more than 8% of the MSCI EM Index’s total exposure. We believe investors in China should focus on consumer staples companies that possess qualities such as strong pricing power like Chacha Food, players in e-commerce that may benefit from regulation such as, and leading industrial businesses such as Wuxi Lead, which is leveraged to the surge in global electric vehicle battery demand.

We think India and Indonesia have the strongest potential growth outlook. Both economies are recovering from deep COVID impacts and were prudent with fiscal stimulus over the last two years. While India’s structural reforms (GST implementation, bankruptcy law, and clean-up of weaker financial institutions) were important, they were a headwind to growth in the last five years. Now with the benefit of these reforms and a much cleaner banking system in place, we are seeing accelerating credit and consumption growth, and the Indian GDP growth rate is forecast to be 6-7% in the coming 12 months.

Lastly, we view consumer staples businesses as resilient, particularly those in underpenetrated categories that have leading and growing market share and strong pricing power.

Stock Selection and Risk Avoidance is Critical in EM

While there is a margin of safety in terms of growth and valuation for EM equities today, there are clearly risks of a prolonged deep global recession. EM is also a tougher space to navigate with lower levels of profitability than U.S. equities. For example, the benchmark MSCI EM Index has lower levels of return on equity versus the S&P 500 (16.8% vs 25.9%), as well as lower net margins (17.2% vs 19.9%) and a higher prevalence of companies with negative earnings (7.12% vs 4.35%), as of August 31, 2022. Thus, the Index can be more susceptible to sharp slowdowns in global growth.

As an active asset manager, we believe we have an advantage when investing in EM. We can construct concentrated portfolios (like the Virtus Vontobel Emerging Markets Opportunities Fund) that offer exposure to structural growth opportunities in EM but at acceptable risk levels to help mitigate the downside. Ideally, investors can strike a balance between faster secular growth and defensive growth stocks, which generally offer higher levels of profitability than the Index and can protect during periods of slower economic growth.

To illustrate this point, here are two examples of unique EM businesses that are hard to find in mature developed markets and that we believe highlight the quality and growth opportunities that exist across cyclical and defensive market segments.

  • Eicher Motors – On the secular growth side, Indian automotive company Eicher Motors has a competitive advantage in the premium motorcycle segment, with its iconic Royal Enfield brand and a market share that has sustained consistently at 90% despite threats from competition. The category remains underpenetrated as Eicher represents only 4% of bikes on the roads in India. Eicher has significantly expanded distribution over the last two years by doubling its point of sale to 2,000 stores while also deepening its lower tier and rural presence. An underappreciated element of the Eicher story is exports, which we think can double over the next five years as its “value for money" positioning and distinctive cruiser bike continues to gain traction. Overall, we think Eicher can grow its earnings at 20% CAGR over the next 5 years.
  • Raia Drogasil (RD) – On the defensive growth side, RD is the largest drugstore chain in Brazil with 14% market share. In our view, it is the only player that can expand nationally in Brazil and continue to take share from independent drugstores, which still comprise some two-thirds of the market. RD can grow retail space at approximately 8-10% per annum on its existing base of 2600 stores over the next 5 years at a ROIC of 25% on new stores, which is among the strongest of any retail format we know in EM. Further, the company has pricing power as Brazil’s regulations allow drug prices to increase by the prior year’s inflation rate. Volumes are supported by the tailwind of expected growth in Brazil’s aging population. Further, we believe RD has a successful online model, which is now 10% of sales and growing at over 40%. Overall, we think RD can grow earnings at 23% CAGR over the next 5 years – a marked contrast to the 8% EPS growth expected for CVS in the mature U.S. drugstore market.

Despite being overlooked by many investors today, EM equities have shown resilience in 2022 from an economic growth and currency perspective. We believe selective investing in a combination of defensive growth stocks (to help mitigate down markets) and secular growth stocks (to help participate in up markets) is the requisite formula to navigate these challenging markets and offers the potential to beat the broader EM benchmark with lower volatility over time.


Investment Partner

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This commentary is the opinion of Vontobel Asset Management. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.

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