Emerging Markets Charts and Views - EM investing after the great repricing

Summary

EM investing after the great repricing

The great repricing of 2022: global financial markets have been caught in a highly gloomy and volatile environment since the Federal Reserve began raising interest rates in an effort to tame surging inflation (at 40-years highs). The tightening of financial conditions has also led to a strengthening US dollar, impacting all asset classes and Emerging Markets (EM) have not been an exception. Moreover, the ongoing war in Ukraine and the Chinese slowdown have further worsened inflationary pressure (via high commodity and energy prices) and harmed economic activity resulting in a deteriorating growth outlook for next year.

For 2023 we still expect a soft landing scenario for the US economy and a recession in Europe, but we also recognise that there are growing risks of a global recession amid high inflation, food and energy crises, geopolitical tensions and tightening in financial conditions.

Against this backdrop, opportunities in Emerging Markets will materialize depending on the evolution of three factors. In particular:

Increasing EM-DM growth differential should play out in favour of the former, with a stabilisation / improvement of China outlook. This will depend on the development of two major challenges that the Chinese economy is facing: 1) its zero-Covid policy, 2) a housing market correction. We do not expect to see a full reopening happen overnight but a more pragmatic approach could be adopted going forward alongside with some normalisation in the real estate sector.
Core rates stabilisation. The hawkish stance of the Fed is now priced in. We are mindful of an alternative scenario of even more aggressive moves, to curb inflation and this is a risk to monitor. A Fed pivot could be supportive for EM assets, and trigger entry points.
EM inflation dynamics and monetary policy are in an advanced stage compared to DM. Most EM have already acted to cool down inflation and most of the tightening cycle could be behind us, the most compelling and significant case is Brazil.

In this context our main convictions in Emerging Markets are:

Entering 2023 we believe EM bonds in Hard Currency can offer interesting opportunities for investors in search of income, while we are more cautious on local rates and FX.
EM equities could benefit from a better backdrop and more visibility later in 2023, but selection will remain crucial amid an increasingly complex EM puzzle.
The internal demand story is still attractive with a mid-to-long-term horizon, raising exposure to China or India as their economic models shift towards domestic demand.

Key themes for investing in EM

	Overall the EM growth gap with DM is going to increase, being a supporting factor for EM in 2023. Chinese stabilisation could mitigate the effects of a global slowdown. But this trend will mainly depend on its reopening, which is linked to the evolution of zero-Covid policy and domestic demand consumption.
	Rapid and significant rate hikes could prompt a recession in DM. We believe most of the core rates repricing has already occurred. Moving towards a new balance between growth and inflation, we expect to see a stabilisation in core rates. This could stop pressuring EM cost of capital and the dollar effect.
	Inflation may already have peaked in some emerging economies. Given their own inflationary dynamics, monetary authorities in EM have been more proactive and advanced in their hiking cycles and we consider that some EM countries have already completed their monetary policy normalisation while others could be close to complete it.
	The main area for attention is a possible further tightening of financial conditions due to a more hawkish Fed, adding pressure to some EM CB and EM FX. Geopolitical risks are still rising due to escalating regional tensions and the ongoing war in Ukraine. The final risks to monitor are idiosyncratic stories and internal vulnerabilities, which are increasing EM fragmentation.