In January, nearly every major asset class saw positive returns. Blame whichever driver you would like for this phenomenon: soft landing narrative, short squeezes, China reopening, managers chasing benchmark returns etc.
Returns have been strong and it has been high-growth, risky assets leading the way in this rally. Which might lead some investors to wonder, if everything is rallying before the market outlook (and valuation) became truly abysmal, are there still growth assets out there that could be considered “cheap”?
We believe the answer lay in emerging markets (EM).
In what is a deep and nuanced asset class, today we will endeavour to provide a broad overview of the current macro landscape and highlight some major economies within the emerging markets universe.
The Landscape for EM
Like most of the developed world, emerging markets went through rounds of severe lockdowns, economic slowdown and inflationary pressures.
We can see that inflation in emerging markets, although historically more volatile and trending at higher levels than a developed market such as the US, experienced the same aggressive post-COVID impulse as we did. (Incidentally it’s never good practice to begin a note with a spaghetti chart, but here we are).
It’s worth noting that the inflationary impulse in these economies has seemingly peaked and is declining meaningfully, Brazil is the standout example here but even more “developed” emerging markets such as South Korea and China have seen things turn.
Part of this has been structural and related to the economic makeup of different regions, but we should also consider the historically higher levels of policy rates EM banks set, and how quickly some regions (namely Brazil and South Korea) were to get ahead of the inflationary issue:
MSCI Emerging Markets vs MSCI World – A Weigh-In
Before we touch on a few regions, how does the MSCI EM index compare to the MSCI World index on some key metrics?
For context, the below is the MSCI EM geographic breakdown:
Compared to MSCI World:
From a sector view, emerging markets do tend to be more of a cyclical exposure, with higher weightings to financials, consumer discretionary and materials – compare this to the relative overweights developed markets have in technology, industrials and healthcare:
However, we opened this note discussing performance and valuations – so how do these numbers stack up?
On a comparative return basis, EM goes through cycles of meaningful out and underperformance to DM – where for the past year, EM has been trying to close up the difference on a rolling YoY basis.
On a valuation perspective, EM has generally traded at a discount to DM – this is to be expected given the future cashflows from companies in emerging economies are generally less predictable/certain than those in DM.
Some Key Regions
Let’s begin this section with a brief insight into our most recent readings from the Innova in-house systematic outputs, a key aspect of our research process which quantitatively produces long and short-term return forecasts across major asset classes. These are only a small sample to compare some major EM indexes versus two DM indexes, one which we hold (UK) and one which we are underweight on (S&P 500).
As the proverbial elephant in the Emerging Markets room, let’s discuss China first. The re-opening of the world’s second largest economy certainly has not gone unnoticed by capital markets, where only a few months ago many prominent investors deemed China as “uninvestable”, relative to the impressive outperformance of MSCI Asia ex Japan we have seen over the past 3 months:
Asia (and China primarily) is an area which we reinvested into late 2022 as a means of adding risk back into client portfolios, in an area which was not necessarily at the still heightened valuations of a market such as the S&P 500:
Granted, the recent rally has driven MSCI China from “quite cheap” at -1 standard deviation of its average, right up to “getting expensive” between November and January.
Key macro indicator: A key macro indicator to watch out for in this region is the China Credit Impulse, which broadly measures the credit cycle in the Chinese economy, and has been a preferred leading indicator for Chinese economic and capital market activity for many years – this measure has been recovering on a rate of change basis after a severe downturn throughout 2021.
Another area which looks poised for growth with historically low valuation levels is South Korea, a market which is not only leveraged to a China reopening story, but is also one of the few markets already forecasting a “worst case scenario” in corporate earnings and multiples.
As a demonstration of Korea’s more ‘recessionary’ earnings outlook, we have compared the Bloomberg EPS consensus on a year-on-year rolling basis, for MSCI Korea versus the S&P 500 – at the start of this year, Korea was pricing in EPS downgrades of -11%, whilst the S&P 500 is still pricing in single digit positive earnings.
This is not to say forecasts are always (or often) correct, but if this is market pricing, then Korea has more risk already priced in and thereby on a risk-adjusted basis appears attractive.
As a heavily export oriented market, Korea is a cyclical exposure – however in the context of overall portfolio construction which may be positioned far more defensively due to DM concerns, a low-multiple, well-priced and economic recovery/reopening levered region may act as a diversifier and hedge in this market environment.
And finally, let’s move across the world to LATAM with Brazil. Brazil ended up being quite a favoured trade with institutional investors in 2022, with geopolitical risks surrounding the presidential election giving way to solid gains in the price of the Brazilian Real and broad equities.
Perhaps unsurprising to most investors, Brazil is often considered a play on industrial commodities, particularly metals such as iron ore – whilst we have yet to come to comfort with some of the idiosyncratic risks surrounding the region, if you believe a China re-opening story will result in significant infrastructure investment, then Brazil is a compelling exposure to that narrative.
Emerging Markets, Emerging Opportunity
In a multi-asset portfolio, it pays to investigate opportunities which offer growth but are not pricing in those growth prospects – or at the very least, have significant structural tailwinds behind them. In this respect, we see that emerging markets do offer some compelling opportunities to add risk back into defensively positioned portfolios, in more asymmetric investment ideas than simply going long developed market beta.
Whilst it does take care and due diligence to identify the risks associated with these opportunities, our outputs and process point towards EM as one of the most attractive short and long term profiles available to investors today.