While 2021 was not a good year for emerging asset markets (EM), 2022 may hold positive developments that could turn the region’s markets around. Our investment view is generally constructive on EM this year, although we are cautious in the near term.
Not so good…
Covid-19 has created supply-side shocks that have hit the global economy with the full extent of the consequences still to play out. Emerging markets with less fiscal power to counter the shock suffered more in 2021. In economic terms, the growth-inflation mix deteriorated visibly, taking the shape of a drop in growth and a spike higher in inflation. The consequence is stagflation risk.
The results of this constellation were clearly visible in equity and bond markets (see Exhibits 1a and 1b).
And next for emerging markets…
Most of the forces that affected these markets in 2021 are still intact. They include further risks to growth and inflation from mutations of the coronavirus, the impact of an increasingly hawkish US Federal Reserve (e.g. perhaps via a stronger US dollar) and the effects of weak growth momentum in China on EM economic growth.
Chinese growth in particular is a crucial factor for growth in emerging Asia. Historically, the region has been more sensitive to changes in GDP growth in China than to shifts in European and US growth (Exhibit 2). So, if growth in China were to slow sharply, even strong growth in Europe and the US might not be able to offset the impact on Asia.
Meanwhile, Covid-19 remains a major risk to the global economic outlook. Emerging markets are lagging developed markets on the vaccine rollout more than two years into the pandemic.
Most regional economies are facing rising cost-price pressures that are spilling over into consumer price inflation and that are keeping central banks on high alert. In fact, many EM banks have already reacted by tightening their policies in response to the rise in inflation. In this area, they are ahead of the curve relative to central banks in many developed markets.
Further concerns are the need for tighter fiscal policy to rein in borrowing at a time when interest rates are rising and when there are threats to global economic growth, and intensifying geopolitical risk.
In a nutshell, a weakening cycle and the prospect of a drop in global liquidity as central banks turn less accommodative form a challenging backdrop for EM. Accordingly, we believe it is sensible to stay cautious on this asset class in the near term.
Room for a brighter outlook
However, these problems are not new. Markets have now priced in a rising inflation backdrop with interest rate increases from leading central banks. The sell-off in 2021 drove down EM equity valuations as well as some currencies and depressed local debt markets. Even hard currency assets were not spared. Arguably, EM assets are now priced attractively.
In addition, there is cash waiting on the sidelines. Investors have been reducing their EM exposure materially for quite some time, resulting in sharply higher cash holdings by many institutional investors.
We believe this set-up forms a favourable backdrop for EM markets to recover if macroeconomic pressures were to ease. Given the sharp correction in these markets, investors are likely to see more positive surprises than negative news.
Potential catalysts for an improvement in sentiment include:
- Positive news on the pandemic
- Easing supply-chain strains
- Improving global and China growth momentum
- EM and US inflation peaking.
Asset allocation: EM equities and Chinese corporate bonds
While we expect above-trend economic growth in the G10 countries this year, with inflation peaking around summer, we enter 2022 cautiously.
From an asset allocation perspective, we are underweight duration relative to our benchmarks. We are overweight selected equity markets that we believe are both less sensitive to the rise in real yields and can boast strong cash flows. EM, along with Europe ex-UK and Japan, fits into this category.
To benefit from an expected improvement in China’s growth as it eases policy, we are tactically positive on commodities, notably energy and base metals.
On EM fixed income, the drop in local currencies can be a favourable factor. The same goes for the improvement in the external balances of many emerging markets. Together with the pre-emptive action against inflation by many central banks, we see a limited risk of capital flight. Indeed, there is a possibility of central bank easing if inflation tapers off over time, adding to the attraction of EM bonds.
Looking at corporate bonds, we believe there could be opportunities in the Chinese property sector where deleveraging-related reforms and regulation have caused prices to fall sharply. We expect the Chinese authorities to not pull the rug from under the sector completely. That leaves room for a recovery.
We foresee two major risks that could delay a bounce-back in emerging markets:
- The prospect of faster tightening by the US Fed. While we expect three rate rises in 2022, there are also calls for four increases, which could cause greater market volatility and higher risk aversion.
- A deterioration in the pandemic could cause further supply-chain disruption, lead to economies being shut down and aggravating investors’ worries about higher inflation or even stagflation.