As we entered 2022, many emerging markets were already hurting due to higher commodity prices and rising interest rates; then a war in eastern Europe sent shock waves through the markets.
That doesn’t change our long-term outlook for emerging markets, where a focus on commodities and consumer necessities has given way to higher-growth businesses in e-commerce, healthcare, advanced manufacturing, and technology (and gotten us excited about the opportunity set). But in the shorter term, our outlook is region- and country-specific.
Let’s take a deeper dive into how we’re looking at emerging markets in light of higher commodity prices, rising rates, and Ukraine.
The Factor View: A Focus on Valuations and Corporate Quality
The chart below shows 25 years of factor performance in emerging markets in rising-interest-rate environments, which we’re experiencing today.
In a rising-rate environment, valuation performed well. But a close second was earning revision strength, because earnings revisions were a proxy for strong corporate fundamentals. Quality was in the middle of the pack, performing moderately well in rising-rate environments. Growth lagged.
For us, there are two key takeaways. First, we focus our investments on high-quality growth companies that we believe possess sustainable competitive advantages, as we always do. Second, given the market’s increased focused in this environment on valuations and earnings disappointments, we’re more tightly managing the risk at companies where we see extreme valuations and deteriorating fundamentals.
The Sector View: Where Are the Winners and Losers?
Industry performance has also been affected by rising-rate environments, and the strongest-performing industries in those environments over the past 25 years have been energy, insurance, consumer staples, banks, and materials.
It’s easy to understand why banks are appealing (and are an area of increased focus for us). They benefit from rising rates because they can lend at rates and earn more money on the loans they provide.
Energy tends to perform well in rising-rate environments because the U.S. Federal Reserve (Fed) typically raises rates when economic times are good, which benefits energy stocks because consumers tend to make major investments.
In energy, though (and materials), it’s difficult to find quality growth companies, especially in EMs. So, we’re focusing on countries that have the potential to benefit from higher commodity prices—countries in Latin America, in particular, and the Middle East, as well as Indonesia.
The relative underperformers are the highest-growth, highest-valuation segments of the market, such as healthcare, technology, and media and entertainment. Nothing is structurally broken in those industries, but they are growing into their valuations. Many are struggling to pull forward some of the COVID benefits they received over the past two years.
This is supported by current metrics. When we plot corporate fundamentals (represented by our earnings trend model) against valuations, the most attractive industries are energy, metals and mining, banks, and diversified financials. On the flipside, industries with more challenging fundamentals and expensive valuations are pharmaceuticals, healthcare equipment, retail, media, and software.
The Country View: Commodity Exporters May Benefit
From a country perspective, there seems to be a theme when looking for countries with solid fundamentals (again, represented by earnings trend) and cheap valuations. Some of the more commodity-driven markets, including South Africa and the United Arab Emirates (UAE), score well. So, too, does Latin America, with Columbia, Chile, Mexico, and Peru scoring positively. But let’s dive into the country outlook in more detail.
The conflict in Ukraine likely bodes poorly for eastern Europe more broadly, expanding beyond Russia to Hungary, Poland, and other countries in the region.
The conflict in Ukraine likely bodes poorly for Eastern Europe more broadly, expanding beyond Russia to Hungary, Poland, and other countries in the region, as my colleague Olga Bitel explained in another post.
There are several reasons for this: eastern Europe is very dependent on energy imports from Russia; it is dealing with a refugee crisis from Ukraine; inflation has accelerated; currencies are under pressure; and interest rates have increased. Generally, then, we have a cautious view of central and eastern Europe.
On the flip side are countries that are commodity beneficiaries, many of which are in the Middle East and Latin America.
On the flip side are countries that are commodity beneficiaries, many of which are in the Middle East (such as the UAE and Qatar) and Latin America.
Banks in Middle Eastern countries may also perform well in the coming years, because interest rates there have tended to rise with U.S. rates.
Latin America also appears to have some other things working in its favor. Countries are reopening after enduring a difficult two years of COVID-related shutdowns, and valuations in some countries (especially in Brazil) are attractive.
We could see a significant weakening of growth in China in 2022, so we’re taking a bottom-up view and focusing on identifying companies with strong underlying fundamentals.
The outlook for Asia is mixed, in our view. India, Thailand, and the Philippines appear expensively valued, while China and South Korea have particularly disappointing fundamentals. But let’s dive deeper into a few countries where we see opportunities, or a reason to pass.
On the upside, in Taiwan we’re seeing strong secular growth trends, in part driven by technology (Taiwan has, to some, become synonymous with semiconductors). Its fundamentals seem strong and valuations are attractive. We believe Southeast Asia, meanwhile, is better positioned, and Indonesia in particular is responding to positive trends, including a post-COVID reopening and higher commodity prices.
India, on the other hand, appears to be an expensive market, and will most likely be hurt by rising energy prices, given its dependence on energy imports.
The question on everyone’s mind, though, is likely, “What about China?” It’s worth digging a bit deeper here, in part because China is such a mixed bag right now.
On the positive side, President Xi begins his third term in the fall, and the government is focused on ensuring a stable economic environment preceding that event. I suspect we will see moderate fiscal stimulus, and on the monetary side, China will probably be one of the only major central banks to ease in 2022. There could be some easing of regulatory pressures, and valuations are also very attractive, in our opinion.
On the flipside, the resurgence of COVID in China will likely impact economic activity there for the first half of the year. Shanghai is in a massive lockdown as I write this post. And that’s showing up in the data. The official NBS non-manufacturing purchase managers index (PMI) for China dropped from 51.6 in January to 48.4 in March, marking the first decline in the service sector since last August 2021. The property market is still under significant stress. And consumer sentiment has been weak since the second half of 2021.
And, as we move into the second half of 2022, the geopolitical risks are still there: midterm elections are coming up in the United States, and our policy regarding China will likely be front and center.
All things considered, I believe we could see a significant weakening of growth in China in 2022, so we’re taking a bottom-up view and focused on identifying companies with strong underlying fundamentals.
We’re also looking elsewhere in Asia. The performance of emerging markets over the past five years has been driven by a concentration in China’s mega-cap e-commerce and technology companies. This year, I believe some of the smaller, peripheral Asian countries could see compelling equity market performance. And those smaller countries tend to have smaller markets with smaller companies. That broadening of investment opportunities by region and market cap is really exciting for us as all-cap investors.
Closing Thoughts: Where’s the Value?
Last, valuations in emerging markets are roughly in line with their long-term average, with an average forward-looking price-to-earnings ratio of about 12x. That’s relatively attractive, and I don’t think emerging markets are getting credit for the significant improvement in benchmarks.
There are fewer state-owned enterprises, commodities, and cyclicals in EM benchmarks today. Those benchmarks tend to be more focused on higher-valuation sectors, such as healthcare and technology. Emerging markets have not yet received that valuation re-rating, so they still appear cheap. In fact, relative to the rest of the world, emerging markets are the cheapest they’ve been since before the global financial crisis 15 years ago.
That speaks to just how drastically emerging markets have changed, in my opinion. The chart below shows that emerging markets aren’t just about growth; they’re about high-quality, high-return companies, and there’s been a shift in investment opportunities there.
Over the past 20 years, we’ve seen a transition in emerging markets from basic consumer necessities, consumer staples, and commodities, to higher-growth businesses in e-commerce, healthcare, advanced manufacturing, and technology. That’s where the growth in emerging markets is, and that’s what really gets us excited as quality growth investors in EMs.
Twenty years ago, companies in the top quintile of what we call “sustainable value creation”—by which I mean companies that are generating high return on invested capital and high return on equity—were primarily in developed markets such as the United States, United Kingdom, and Europe. Emerging markets were just a little more than 10% of the top quintile of sustainable value creation.
Today, emerging markets represent 35% of the top quintile of sustainable value creation—a strong trend toward innovation, quality and growth. And while we will likely see periods of cyclical underperformance in EMs, I believe they will be short-lived, and these longer-term trends should re-assert themselves quickly. And that should create opportunities for quality growth investors.
Global Disruption Series
Part 1: Before and After: How Ukraine Changed Our Outlook
Part 2: Factors, Sectors, Countries: Opportunities in Emerging Markets
Part 3: Shifting Opportunities in an Atypical Landscape
Casey Preyss, CFA, partner, is a portfolio manager on William Blair’s Global Equity team.