2023 Outlook for Emerging Markets

Inflation remains a multi-layered challenge for policymakers. – by Chetan Sehgal

 
Whilst the shift from easier policies during the pandemic to tighter policies in a supply chain-constrained world may previously have taken place at a slower pace than required, there is no doubt that central banks have fully reasserted their inflation fighting credentials.

By mid-November 2022, the US Federal Reserve had raised interest rates six times this year, by a cumulative 3.75% to 4.00%, the highest level since January 2008. Inflation in the euro area meanwhile rose to a record 10.6% in October 2022, which is likely to lead to
further interest rate increases by the European Central Bank.

Interest rate increases in emerging markets (“EMs”) have been less than developed markets (“DMs”), reflecting more subdued inflationary pressures, helped largely by significantly less fiscal expansion during lockdowns. Using real interest rates as a proxy for the monetary policy stance, markets such as Brazil are experiencing tight monetary policy, whereas policy in the US and Euro Area remain loose.

This has implications for the timing of eventual interest rate cuts, with Brazil likely to join China in cutting rates in 2023. In isolation, this would be positive for investors. However, it is important to acknowledge the challenging global backdrop and the need to see an improvement in global growth and/or a weaker US dollar to enable the positive impact of lower interest rates to filter through to the market in these countries.

The Chinese property market continues to struggle, which is impacting domestic growth as well as demand for key commodities involved in construction, including cement and steel. A 40% decline in new real estate construction starts as well as single-digit growth in infrastructure investment have contributed to the weakness in growth.

Slower global growth, a strong US dollar, global supply chain woes as well as domestic economic factors have created headwinds for EMs. Nevertheless, there is long-term growth potential, as economic growth in EMs has continued to outpace that in DMs.

EMs are home to companies with exposure to new technologies driving future sustainable economic growth. From solar and electric vehicle battery producers to semiconductor designers and manufacturers, the acceleration of innovation in EM is driving confidence in the asset class. Despite the current challenges, there continue to be opportunities to invest in companies with a technological edge which are investing to drive growth.
 
Chetan Sehgal is lead portfolio manager, Templeton Emerging Markets Investment Trust