Room for cautious optimism in emerging markets?

A weaker dollar may mean a better 2023…by David Kimberley

 
Emerging markets investors did not have a pleasant 2022. The iShares JPMorgan USD Emerging Market Bond ETF, which saw its net asset value decline by 18.0% in the 12 month period, provides a simple snapshot of why that was the case.

Country specific reasons partially explained poor performance. Spiraling inflation in Argentina, political uncertainty in Brazil and China’s zero covid policies hardly inspired great enthusiasm among investors.

A rapidly appreciating dollar played the primary role though, with a stronger greenback making life difficult for companies across emerging markets, which tend to have local currency revenues but dollar costs, as well as governments, who face a similar problem when paying dollar denominated debt.

Pessimism has seeped into the closed-ended fund sector as a result and there are now four trusts in the AIC’s emerging market sector trading on discounts in excess of 10%, with Templeton Emerging Markets (TEM) on a notable 11.9% discount. Are investors right to still be pessimistic though?

Markets as a whole seem to be enjoying a level of cautious optimism since the start of the year. For emerging markets, a weakening dollar seems to be inspiring some confidence of a bounce back.

The EM bond ETF mentioned at the start of this piece, for example, has risen over 10% since October. Assuming the dollar does either stay at current levels or continues to decline in value, it is likely investors will see this as a positive for emerging markets.

China’s decision to stop cooping everyone up at home provides another reason for cautious optimism. The government is also showing signs of enacting more business-friendly policies, after several years of cracking down on everything from real estate developers to private tutors.

Research from Morgan Stanley, itself based on the outcomes of a government meeting held in December, suggests the CCP will continue to ease monetary policy, as well as providing funding for public infrastructure projects and tax credits for private investment.

Large risks do remain, but the government has also taken steps to shore up the property sector. It is also keen to revitalize the private sector after several years of regulatory crackdowns, with the government calling on tech firms to drive growth and encouraging foreign investors to return.

Away from the world’s second-largest economy, Latin American economies may also offer some attractions. The region was, by and large, ahead of the curve on rate hikes. Higher commodity prices also supported returns for companies in the region last year, something that also meant some countries, notably Brazil, did not see substantial currency devaluations against the dollar.

The region is not without risks and it seems likely major economies in the region will go into recession this year. However, as they were ahead of the US on tightening monetary policy, it’s also likely they’ll be lowering rates before most other parts of the world as well.

As I’ve hopefully conveyed, none of this is to say that it’s going to be smooth sailing for emerging markets, butut there are some reasons to think things may improve this year. October saw the MSCI Emerging Markets Index hit its lowest level since the financial crisis 16 years ago. A weakening dollar, China reopening and rate cuts in Latin America may change that in 2023.
 

 

Disclaimer

This is not substantive investment research or a research recommendation, as it does not constitute substantive research or analysis. This material should be considered as general market commentary.