Emerging market resilience points to opportunities

Key takeaways

• Emerging markets suffered a ‘perfect storm’ of economic shocks over the past three years. While conditions have not yet normalised, the outlook has improved for many
• Inflation has probably peaked: energy prices have fallen and the US dollar is weakening. Fundamentals have improved, including more debt in local currency, larger currency reserves, more robust domestic currencies, and lower current account deficits
• China’s reopening is the most important growth driver for many emerging economies, especially in Asia. Other supportive factors include recovering tourism and ‘friend shoring’ supply chains
• We recently increased our emerging equities positions, where we see strong earnings driving returns. In fixed income, we prefer Brazil sovereign bonds and emerging credit. A recovery favours emerging currencies compared with the US dollar.

Many emerging markets are bucking an historic trend. Rather than staggering to the brink of financial instability as economic growth in the US and Europe slows, some look reasonably resilient thanks to China’s reopening economy, a weakening US dollar and slowing inflation. For international investors, that makes select emerging financial assets worth watching.

Over the past three years, the pandemic affected every economy, but not equally. As Covid’s public health impacts eased in 2022, war in Ukraine and rising demand for goods and services triggered rising food and energy prices. These pressures were exacerbated by the slow Chinese economic growth. The result was especially painful for economies from Latin America to Africa and Asia, where food and fuel make up a larger share of household spending than most developed countries. As a strengthening US dollar intensified the inflationary pressures on emerging exporters, central banks everywhere responded with higher interest rates.

While 2022 delivered a series of economic shocks for emerging economies, markets from Brazil, to India, South Korea and Taiwan are now well positioned to grow in 2023. Inflation remains high, but has probably peaked, and Asia’s economies are disproportionately benefiting from China’s reopening. Meanwhile the US dollar is weakening and inflation is slowing amid lower demand in the US and Europe, and declining energy prices. The outlook in emerging markets now looks healthier than for developed economies. That said, economic conditions have not yet normalised, although the worst of the shocks look to be behind us.

Strong fundamentals

China is seeing the greatest single change in prospects. 2022 saw China record its slowest GDP growth in decades – at 3% – excluding 2020’s pandemic slump. Many of the factors that undermined growth, including a crackdown on technology firms, property market turbulence, a strict zero Covid policy, and a population less well-protected from Covid, are now being reversed. In India, a new market-friendly budget should offer a further economic boost, and Brazil’s economy, under a new government, may benefit from interest rate cuts as soon as the second quarter of 2023.

Emerging markets are not only about China’s reopening. The worst pressures of high energy prices have faded. Though emerging markets are a mix of net energy importers and exporters, falling oil prices help the two largest economies, China and India (but hurt producers such as Brazil). The price of Brent crude remains high, but has dropped from a March 2022 peak of almost USD 128 per barrel to around USD 85 today.

Economic fundamentals are also stronger compared with past economic slowdowns. More debt is denominated in local currencies, and financial markets in these economies have deepened. Combined with lower current account deficits and larger foreign currency reserves, many emerging markets now boast more robust domestic currencies. China accounts for a large part of the currency reserve increase, an estimated USD 3 trillion, while India and Brazil together hold nearly another USD 1 trillion.

The China effect

In addition, the process of reopening that is providing a domestic boost to China’s economy should prove more durable than most developed markets’ experience in 2021. China’s strict lockdowns were not accompanied by the social support payments and job protection that cushioned the financial impact on households in Western Europe and North America. With lower household savings, the increase in Chinese consumer demand may prove both more subdued, and longer-lasting.

Renewed tourism should also contribute to longer-term economic growth. In 2019, before the pandemic, China recorded 155 million tourist visits outside the country, and spent an estimated USD 253 billion. Tourist numbers may reach 110 million in 2023. Much of that increase may not materialise until the second half of 2023, but should provide a lasting boost to destinations such as India, Thailand or Japan.

Read also: Japan’s path to normalising monetary policy

While China’s increasing demand is a positive for emerging exporters, so too is the trend toward ‘friend-shoring’ since the pandemic. Covid’s bottlenecks encouraged international firms to diversify their logistics, which largely translates to relying less on Chinese manufacturing sources and should offer countries such as Taiwan, Vietnam and Mexico a higher share of global trade flows.

Investment preferences

In regional terms, we expect South Asia, including India, to enjoy the best long-term growth potential, while growth in Latin America and Eastern Europe is more uncertain. The overall outlook for emerging market assets has improved along with these better economic prospects. However, while the outlook is improving, we are adjusting our allocations step by step, and watching for confirmation of better conditions.

Read also: India’s promised boom