Last year was difficult for emerging market equities, but there are indications that performance could improve in 2023, and the case for long-term allocation to this asset class remains undimmed.
In 2022, emerging market equities suffered their worst year since 2008. The MSCI Emerging Markets index fell by over -20%, dragging behind developed markets, despite an uptick in December. China, South Korea, and Taiwan (which make up almost 55% of the index) weighed on performance, overshadowing strong returns in Brazil, India, and the Middle East.
What next for emerging markets in 2023? China, which reopened its economy at the end of last year, is tipped as the ‘one to watch.’ But will it regain its status as the engine of global growth? How might the region – and indeed the global economy – stand to benefit from a reversal of the negative factors emerging markets experienced in 2022?
What are ‘emerging’ markets?
Equities, bonds, and indices can belong to either ‘developed’ or ‘emerging’ markets. Developed markets (‘DMs’) are characterised by their maturity, often having well-established political regimes, capital markets, and high standards of living. DMs include North America, most of western Europe, Hong Kong, Japan, New Zealand, and Singapore.
By contrast, emerging markets (‘EMs’) tend to be growing faster than developed markets. They may be industrialising and experiencing population growth but have lower income per capita than DMs.
Emerging markets are riskier than developed markets because they can experience political instability, illiquidity and currency volatility, and a high level of state-owned or state-run enterprise. To compensate for these risks, EM investors tend to demand a higher level of return. Emerging markets include China, India, parts of Eastern Europe, Latin America, the Middle East, and Russia.
In December, the Nutmeg investment team raised our exposure to emerging market equities across our portfolios. We think there’s opportunity here for investors and see four key reasons why EMs may rebound in 2023.
1. The US dollar is weakening, and the US central bank is expected to stop raising interest rates
In 2022, a strong US dollar and the Federal Reserve’s interest rate rises were headwinds for EMs. A stronger dollar makes borrowing conditions harder for many EM governments and companies, and coupled with higher interest rates, can also discourage capital investment in ‘riskier’ markets like EMs. It’s unlikely these factors will be of the same magnitude in 2023. As the Fed is expected to soon finish raising interest rates, the bar for the dollar to climb further in value seems high. This would likely give a sustainable boost to emerging markets which were negatively impacted by these two correlated factors last year.
2. Global trade appears resilient
Many emerging markets still rely on exports for growth. For instance, Latin America is a key exporter of commodities, while Russia and parts of the Middle East are oil exporters. Over the last two years, nearly every major emerging market economy has experienced a double-digit increase in goods exports. Global trade is looking resilient, which should be supportive for EMs, provided that the slowdown in the economy doesn’t become too pronounced.
The chart below shows world trade volumes over the past 20 years. You can see how the data has normalised following the worst of the Covid pandemic in 2020.
Chart 1: CPB Merchandise World Trade Volume Index (2000-2022)
Source: Nutmeg/Macrobond, January 2023
3. Supply chain pressures are easing
Supply chain difficulties continued to recede in 2022. The price of shipping goods by container rocketed throughout 2020 and 2021 as the pandemic disrupted supply chains. Thankfully, the stress that was apparent in 2021 and for most of 2022 is now abating, and returning to a more typical level, potentially bringing an end to the difficulties EM exporters have experienced for the last 24 months.
4. India is looking strong
We think India – which has been a positive contributor to EM performance – has the potential to remain strong in 2023. The Indian equity market has grown as a percentage of the EM index: it stood at 8.5% before the Covid pandemic, and is now more than 14%, making it the second-largest component outside of China.
Potential growth for the Indian economy seems robust, and it is not significantly impacted by difficulties seen in its neighbour, China. Furthermore, the Indian political landscape seems to offer more stability, and is perceived as more “open for business” than what we see in mainland China (and by extension Hong-Kong), even if corporate governance in India still remains fragile.
China: The bellwether of emerging markets
As the largest emerging economy, and the world’s second-largest economy, China will be key to any EM renaissance. After a challenging 2022, will the year of the Rabbit – which symbolises good luck – bring the country fortune in 2023?
On the one hand, things are looking good. The economy is expected to fully reopen this year, with domestic consumption and international investment set to rebound as a result. The challenges faced by some sectors of the economy last year appear to be easing.
After being heavily regulated in 2022, tech stocks are staging a recovery rally, with Hong Kong’s Hang Seng Index up significantly since October. The property sector, which accounts for around a quarter of economic activity, was left shaken by the Evergrande crisis in 2021. But now policymakers are set to ease their ‘three red lines’ policy to support developers. Bond yields have been stable, which encourages investment and aids credit issuance.
On the other hand, China is facing headwinds. There remains an element of domestic and international caution, particularly as fatalities from Covid increase. China relies on net exports as a source of economic growth, but with growth weakening across the global economy, 2023 may see demand fall.
Demand from Europe and the US may weaken, which could cause some localised contraction. Moreover, in 2022, China’s population declined for the first time in 60 years, while GDP growth is a fraction of what it was before the 2008 financial crisis.
On balance, we think that China should experience strong economic growth in 2023, but that it will be tempered by falling exports, making consumer spending and business investment even more critical.
Structural risks include an ageing population and geopolitical tensions with the US, but the rally in Chinese equities is becoming harder for investors to ignore. China could help lift the broader global economy in what would otherwise be a year of contraction.
The key takeaways for investors
Looking at the bigger picture, developed markets have long been seen to be handing the ‘baton of growth’ to emerging markets for long-term investors, the ongoing industrialisation of these countries, and the overall positive demographic picture, suggests they will continue to flourish. However, as we have seen in recent times, there are periods when emerging economies will struggle. A geographically diverse, multi-asset approach, holding both developed and emerging markets is a sensible way to invest, and the approach we take at Nutmeg.
In the immediate shorter term, the continued reopening of China will be a key driver for EMs this year, so long as demand from developed markets doesn’t weaken too much.
China’s reopening is expected to lift demand for oil and other commodities, which would benefit exporters, but could raise inflation and weigh on growth in other emerging and developed economies. Finally, a weaker US dollar could be the key to emerging markets outperformance in 2023.
Will investors get the higher returns they expect from these higher risk environments? It remains to be seen. We would typically expect GDP growth to be higher in emerging economies than in developed countries. This ‘growth differential’, which acted for years as a strong positive catalyst for foreign flows and equity returns, is smaller now than what was often experienced prior to Covid. This differential would need to be present again in 2023 and going forward to compensate for higher level of risk inherent to emerging countries, so we’ll be monitoring this closely in the months ahead.
As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance