In two-thirds of the emerging economies that we track, consumer price pressures are increasing, with year-over-year inflation reaching 6.5% or higher. At the same time, real economic activity is softening, as seen in the weakening trend in imports, retail sales, industrial production, and purchasing managers’ indexes.
China has been the notable exception to the rule. The country’s distinct stage in the business cycle can in good part be explained by its unorthodox approach to handling the pandemic. Following weeks of economically damaging lockdowns, China has man-aged to bring the latest omicron wave under control. Inflation remains subdued, and reopening tailwinds and fiscal stimulus are allowing economic growth to recover from very low levels.
But emerging markets’ drift toward stagflation may not be over yet. As long as China’s zero-COVID policy remains in place, a start-stop pattern to its economy seems likely to emerge. The war in Eastern Europe has no end in sight, with Russian gas supplies to Europe in question. The Federal Reserve, the Euro-pean Central Bank, and even those emerging market central banks that had begun to normalize policy have further rate hikes to deliver so as to tame inflation. After all, real short-term interest rates in much of the world remain in deep negative territory.
In this context, US equities have been skirting around bear market territory over the last month, and the likelihood of one eventually consolidating is rising. It is therefore informative to study how emerging market assets have behaved in prior such episodes. Reliable performance data for the region is only avail-able for the last three instances of over 20% correction in the S&P 500—in 2001, 2008, and 2020. Although not a pleasant environment by any means, and acknowledging the sample size is too small to draw inferences with confidence, emerging markets have historically held up surprisingly well.
The economic outlook remains uncertain and the range of possible outcomes wide. In our view, emerging market assets today offer portfolios an inexpensive way to diversify. While US stocks have only recently reached long-term valuation averages, emerging market equities are already trading at an 11x forward price-to-earnings ratio, well below their 10-year mean. And although US high yield bonds are showing moderate signs of stress, with spreads over US Treasuries at their 60th percentile of the last two decades, emerging market bonds are more heavily discounted, with spreads standing at the 90th percentile over the same period.
More specific opportunities also lie within fixed income. In our Emerging Markets Bond List, we cover a range of corporations that are global champions in their respective industries. Many exhibit relatively strong credit metrics, are led by management teams with proven capability in handling the different stages of the business cycle, and have fairly high corporate governance standards. Our investment themes “Yield opportunities in LatAm“ and “Short-duration Pan-American bond opportunities” present some of our highest conviction calls.
In the equities space, we continue to expect high-quality earnings growth leaders such as internet and e-commerce companies to outperform emerging markets at large, and environmental, social, and governance (ESG) leaders to help mitigate portfolio risks. Geographically, China remains a most preferred market thanks to its idiosyncratic business cycle dynamics described above.
It’s unclear whether a tough 2022 will eventually offer investors a respite. Avoiding concentrated positions and exploring options in emerging markets can help investors mitigate some of this year’s portfolio damage.