Emerging markets: a constructive 2022 in sight

There are several reasons to be constructive about emerging markets (EM) as we approach 2022.

  • Equity valuations appear to have been priced very cautiously and point to attractive long-term value.
  • Chinese market valuations appear to be near a bottom and should be well supported from here after significant negative news out of 2021. While near-term headwinds from regulatory uncertainty and its “zero -Covid-19” could last until 2022, policymakers stand ready to stabilize economic growth if necessary.
  • Across emerging markets, positive structural forces remain apparent and are likely to create new investment opportunities. digitalization and decarbonization are key themes to watch.
  • The fiscal and current accounts are also in better shape than before, potentially ruling out a repeat of the severe market stresses that have plagued emerging markets in previous down cycles.

Measured optimism

2021 has been a tough year for MS. Mixed progress in immunization in countries has contributed to false starts in emerging from the pandemic. Economic reopenings in emerging markets and reopening of trading in their stock markets then lagged behind those in developed markets (DM). China was a major concern – tighter fiscal and monetary policies, the “common prosperity” campaign driving regulatory changes across sectors and a combined zero-Covid-19 approach to chill investor sentiment. Concerns about US inflation and the stance of US monetary policy also came to the fore. Major emerging countries such as Brazil, Mexico, Russia and South Korea have outpaced developed countries in raising interest rates to curb price pressures.

Still, there are several reasons to be constructive about the approach of emerging markets in 2022. For starters, equity valuations appear to have been priced very cautiously and point to attractive long-term value. The outlook for fixed income is also encouraging: real returns in emerging markets are outpacing those in developed markets. In this regard, we note a shared optimism in emerging markets with our bond colleagues.

EM fiscal and current accounts are also in better shape than before. Institutional reforms in major emerging markets over the past decades have strengthened their economic discipline and resilience to crises. High commodity prices have recently been an additional boon for resource exporters. Stronger emerging financials potentially preclude a repeat of the severe market stresses that have plagued emerging markets in previous down cycles.

Various EM Drivers

Valuations in the Chinese market appear to be close to a bottom and should be well supported from here after significant negative news out of 2021. Certainly some short-term headwinds could carry over into 2022. We expect for China to maintain its zero-Covid-19 position long after the year to safeguard the success of the Winter Olympics and the 20th National Congress of the Communist Party of China. International travel and other mobility restrictions will limit economic activity. Regulatory uncertainty could also persist. We believe recent regulatory changes are partly a function of China’s political cycle, which will likely culminate with the 20th National Congress. As the political dust settles, regulatory clarity should eventually return, as it has in past political cycles.

On a positive note, the Chinese authorities have shown that they still have a solid growth agenda and have no intention of stifling the private sector with rules. They have the policy tools needed to stabilize growth and are ready to use them if necessary, as we saw with the recent reduction in the country’s reserve requirement ratio.

In Brazil, valuations have fallen to extremely low levels, creating attractive investment opportunities. Concerns about possible fiscal laxity, rising interest rates and the likelihood of a resurgence of the left in next year’s general election led to the market selling off. Even then, Brazil’s fundamentals look healthier to us than they have since its last recession. More recently, its fiscal and current accounts have improved, with higher oil prices helping the net oil exporter. The macroeconomic tailwind has also manifested itself at the corporate level. For example, streamlining and increased cash flow, aided by higher oil prices, has enabled state oil producer Petrobras to significantly reduce its debt in recent years.

India’s economic activity has rebounded since its second wave of Covid-19. The credit cycle showed signs of recovery and major banks recorded healthy loan growth. The housing cycle has also accelerated due to improved housing affordability, as well as a pick-up in the infrastructure cycle as part of the government’s infrastructure efforts. A robust fiscal position and current account accompanied India’s cyclical acceleration.

Secular Opportunities

Across emerging markets, positive structural forces remain apparent and are likely to create new investment opportunities. digitization is a key theme. India’s booming internet economy has attracted capital looking for new areas of growth, especially in light of regulatory flows in China. E-payment, food delivery and other disruptive business models have taken off, prompting even traditional businesses to embrace innovation to counter competition. In China, industrial digitalization has accelerated as the economy plans to move up the value chain. Globally, the continued shortage of semiconductors underscores the huge demand for chips resulting from technological advances, and we expect strong earnings for some of the world’s largest semiconductor companies in markets such as Taiwan and South Korea.

Decarbonization is another trend to watch. Pledges from major emerging markets to achieve carbon neutrality are expected to ramp up electrification and renewable energy efforts, creating multi-year support for affected industries. We have seen the growth of South Korean EV battery makers and Chinese solar energy companies accelerate sharply, elevating them to global industry leadership positions.

Risk resilience

Certain risks could alter our overall outlook for emerging markets, even if they are not in our base scenario. For example, a sharp and sudden rise in the US federal funds rate could trigger market volatility. Conversely, a dovish political surprise in the US could help emerging markets outperform developed markets. Meanwhile, more dangerous variants of Covid-19 could emerge amid the ongoing pandemic. The market swings following the recent discovery of the Omicron variant are a reminder of the uncertainties that remain, although indicators so far suggest the variant’s symptoms may be milder than expected. We are also monitoring China-Taiwanese relations as cross-strait tensions mount.

As the investment environment evolves, an important characteristic we look for in emerging markets is resilience, both in their economies and in companies. What particularly matters to us is the sustainability of business profits, whether in the face of Covid-19, policy changes, technological disruptions or other challenges. We see companies with structural growth drivers aligned with digitalization, decarbonization and other transformative trends emerging as long-term winners, which should support emerging market equities.

What are the risks ?

All investments involve risk, including possible loss of capital. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. There are particular risks associated with investing in foreign securities, including risks associated with political and economic developments, business practices, availability of information, limited markets and exchange rate fluctuations and policies; investments in emerging markets involve increased risks related to the same factors. To the extent that a strategy focuses on particular countries, regions, industries, sectors or types of investments from time to time, it may be subject to greater risks of adverse developments in those areas of interest than a strategy that invests in a wider variety of countries, regions, industries, sectors or investments. China can be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks specific to China, including certain legal, regulatory, political and economic risks.

There can be no assurance that any estimate, forecast or projection will occur.

Franklin Templeton is Manraj Sekhon, CIO Emerging Markets Equities.

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