Brazil and China show emerging markets’ diverging fortunes

Key takeaways

• Emerging markets have seen divergent economic performance in 2023, amid US dollar strength, oil prices and China’s weak growth. In contrast, demand for tech, friend-shoring or advanced monetary policy cycles have boosted others
• China’s growth may slow to 5% this year and 4.3% in 2024, remaining between 2% and 4% in the decade ahead. We await additional reforms from the forthcoming Communist Party plenum
• Brazil has positively surprised investors with a bumper harvest, improving economic growth, domestic reforms, falling inflation and interest rate cuts
• We take a selective approach to emerging market allocations. We are underweight the Chinese currency and in portfolios keep an overweight position in Brazilian local currency debt and the Brazilian real.

Emerging markets’ performance through 2023 has depended on diverging monetary policies, the US dollar’s strength and exposure to a slowing China. While these economies have never been a homogenous block, 2023 is proving a year in which investors need to be highly selective. Our investment positioning focusses on a positive outlook in Brazil, and a more nuanced one on China.

Divergent stock market returns this year underscore the divergent fortunes of emerging markets (EM). Mexico, which has benefited from the ‘friend shoring’ trend in the manufacturing sector, has recorded returns of almost 20% year to date in US dollar terms. Both South Korea and Taiwan’s markets have benefitted from improving outlooks for their technology sectors, thanks to artificial intelligence and electric vehicles. In US dollars, Brazil’s stock market has been one of the better performers, roughly matching the 13% year-to-date total return of the S&P 500. In contrast, a slowing Chinese economy has spilled into other Asian economic performance, and the MSCI China index recorded a 7% loss in dollars by the end of September.

One headwind for many emerging markets has been the comparative resilience of the US economy, which has boosted real returns and thus investor demand for US financial assets over many of their EM counterparts. Many emerging currencies have depreciated against the dollar this year. Higher crude oil prices, which we expect to remain around USD 90 per barrel for the rest of this year, have also acted as a drag on net oil importers, including many emerging Asian economies. In addition, disruptive El Niño weather patterns through 2024 create new risks for emerging markets, where food makes up a significant share of total consumer price inflation.

One of the key setbacks for emerging economies this year has been China, where historical rebounds in domestic demand have lifted others’ industrial activity. China’s growth has accelerated since 2022, but has underwhelmed markets in 2023. Although there are signs of stabilisation after the weak second quarter, private sector capital expenditure and service sectors continue to slow, partly due to real estate turmoil. We expect that piecemeal stimulus and gradual structural reforms will see growth slowing from this year’s 5% to 4.3% in 2024.

China’s longer-term prospects

Over the next decade, Chinese growth should slow to between 2% and 4%. The country’s structural slowdown should not surprise markets as growth below 5% is a natural level for a relatively industrialised middle-income economy. The real question is China’s ability to cushion this long-term transition with stable inflation and market-friendly reforms to empower the private sector and consumers. Amid signs of household and private businesses deleveraging, foreign investors seem to anticipate a volatile transition.

China’s leadership has an opportunity to advance reforms. The Communist Party’s 20^th Central Committee will hold its third plenum in October or November. This meeting is usually dedicated to medium-term economic plans and structural reforms. Any change of the ‘hukou’ residence system, urban land allocation, property taxes, retirement age, social safety net, and capital markets, could counter market pessimism.

In the short-term, Beijing may do more. Fiscal support for local governments struggling with large debt and widening funding gaps is key. An announcement combining special bond issuance that can be swapped with local government debt is likely, plus central government transfers potentially totalling as much as two trillion renminbi (USD 280 billion).

We have been cautious on the Chinese renminbi given weakening balance of payments trends and a diminishing yield advantage. Most recently, authorities have intervened to anchor the USDCNY exchange rate around the 7.30 level. This narrows space for aggressive monetary policy easing beyond targeted liquidity provisions or cuts in reserve requirement ratios (RRR). If conditions deteriorate again, the government may still let the currency weaken in the face of fiscal stimulus limits and we remain underweight in the renminbi.