With improving growth projections and structural economic changes, emerging markets are attracting investment in both equities and fixed income.
May 18, 2023
Managing Director, Head of Investment StrategyRBC Europe Limited
In a reversal of last year’s trend, investor fund flows have returned to emerging markets (EM) in 2023. According to EPFR Global, $39 billion has been invested in EM equities year to date, and a more modest $2 billion into EM fixed income. Investors have been attracted to what seem to be long-term structural changes, such as greater adherence to monetary policy orthodoxy and the prospect of a commodity supercycle, while the growth differential in favor of EM over developed markets (DM) has widened markedly.
New monetary orthodoxy — Many EM central banks had the foresight to start monetary tightening much earlier than their DM peers. With the medicine applied early, interest rate hiking cycles are now coming to an end, while inflation is trending lower and has reached the single digits in most countries. Consensus expectations have interest rates declining in India and most of Latin America before year’s end, and in some Eastern European countries next year.
Monetary tightening has also helped underpin local currencies, as a high pickup in real bond yields compared to developed markets has attracted capital over the past several months. At present, the real yield differential in six large EM economies (Brazil, Indonesia, India, Mexico, Poland, and South Africa) is roughly five percent.
A commodities supercycle? — Commodity prices have staged a remarkable recovery since mid-2020, benefiting from the reopening of economies after the pandemic and from increased demand for critical industrial minerals needed for the clean energy transition. Price gains were also extended due to the Russo-Ukrainian war, which deprived markets of two important suppliers. As a result, prices for both industrial metals and the agricultural complex are much above recent averages. Given rapidly growing demand and the difficulty of ramping up supply quickly, there is increasing talk of a commodities supercycle.
Line chart showing the Commodity Research Bureau Index, an index of industrial and agricultural commodities, over the past 5 years. The index is a representative indicator of global commodities markets. The index slumped when COVID-19 struck but gained rapidly and exceeded previous levels as economies reopened. The Russo-Ukrainian war caused a peak in prices. They have receded since, but remain above their 5-year average of 479.
Note: CRBI is an index of industrial and agricultural commodities
Source – RBC Wealth Management, Bloomberg; data through 5/12/23
Many EM countries are generously endowed with natural resources, so their economies are tightly linked to commodity prices. Resource stocks represent some 15 percent of overall EM market capitalization, according to our national research correspondent, and therefore EM equities tend to benefit from rising commodity prices.
Improving growth differential — Overall, consensus has upgraded 2023 economic growth forecasts for EM economies, even as DM forecasts have been downgraded.
During 2023, outlook upgrades for Asian countries which benefit from China’s reopening and for some Middle Eastern countries have more than offset downgrades in Latin America, Eastern Europe, and Africa. As DM economic growth prospects dimmed due to banking woes, EM countries’ economic growth differential relative to developed markets improved. Historically, when EM growth exceeds DM growth, EM equities tend to be well supported, according to our national research correspondent.
Consensus estimates now call for EM GDP growth to reach 4.2 percent in 2023, up from 3.1 percent early this year, while DM GDP growth expectations have been pulled back to 0.9 percent from 2.6 percent.
Source – RBC Wealth Management, Bloomberg; data as of 5/15/23
EM corporate earnings forecasts have been similarly revised upward, again in contrast to DM forecasts which have been downgraded. MSCI now expects EM earnings to grow by 2.1 percent in 2023, in contrast to the 2.7 percent contraction expected at the beginning of the year; 2024 earnings expectations have improved to 17.4 percent from 13.7 percent over the same period.
These developments bode well for the asset class, but in our view they bear close monitoring as cyclical considerations may be coming back to the fore.
Monetary orthodoxy has its cost — Interest rates are in the double digits in several countries, including Hungary, Egypt, and some Latin American states. This is not sustainable, particularly where economies or companies are highly indebted. Mark Dowding, chief investment officer at RBC BlueBay Asset Management LLP, points out that stress is building in some fringe emerging markets and a number have had to restructure debt, including Zambia and Ghana. He believes more restructurings could be in the offing as weaker economies struggle with a “toxic mix of elevated debt levels, plus higher U.S. rates.” With many countries holding national debt in U.S. dollars, the 500 basis point (bps) interest rate increase has proven particularly painful.
Eric Lascelles, chief economist at RBC Global Asset Management Inc., notes that from the point of view of an EM fixed income investor, the situation is not alarming because the countries which have defaulted and those under duress (i.e., where the spread of local bonds to U.S. bonds is greater than 1000 bps) represent less than three percent of EM market capitalization.
Polina Kurdyavko, head of EM at RBC BlueBay, believes that emerging market policymakers have gained a lot of credibility by staying on the front foot during the interest rate hiking cycle. She opines, however, that the challenge now is to transition from a stance of tight monetary policy and relatively loose fiscal policy, adopted to counter the effects of the COVID-19 pandemic and the Russo-Ukrainian conflict, to more dovish monetary policy and more conservative budgets. Execution, she says, will be key.
Commodities supercycle on hold for now? — While long-term opportunities remain for commodities, in our view, prices have weakened this year on concerns that consumption may wane as the global economy slows. Energy prices are down some 15 percent, while industrial metals are down some 10 percent.
The fates of most industrial commodities are tightly linked to China, whose recovery seems uneven. Moreover, this recovery is unusual in that it is being driven by household consumption, particularly in services, so it will likely be less beneficial to commodity-exporting EM countries. China’s recent housing market recovery could potentially support demand for commodities, but only if the current rebound continues and proves to be built on more than post-pandemic pent-up demand.
We think fixed income represents the most attractive EM opportunities for investors as monetary policy is gradually being relaxed. In our view, EM bond credit spreads more than compensate for a deterioration of credit quality in the countries which are under duress. Being selective remains of prime importance.
Risks are more finely balanced for EM equities. Valuations are supportive, with the MSCI Emerging Markets Index trading on an 11.9x forward price-to-earnings ratio and 1.6x price-to-book value, but it is hard to see the asset class decoupling from U.S. equities if one or more of the three risks outlined in a recent article were to materialize. We advise a Market Weight allocation to Asia ex Japan.
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.
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