Emerging Markets Quarterly Outlook
January 2023*
A New Year and a Less Synchronized Cycle
China’s swift exit from its zero-Covid policy should result in a growth rebound this year, while tight central bank policy continues to weigh on the US and European growth cycle. Global headwinds remain, but a desynchronized cycle creates opportunities within emerging markets.
The global outlook is starting the year with some reasons for optimism: 1) global inflation is showing early signs of moderating; 2) Chinese growth is expected to accelerate closer to trend growth this year; and 3) financial conditions have eased since October. In combination with attractive valuations for the MSCI EM index, the backdrop appears slightly brighter for EM equities than last year. Still, the improvement in the EM outlook must also be tempered with more persistent headwinds for pro-cyclical assets more broadly.
The Federal Reserve and other major central banks continue to tighten policy as inflation tracks above target rates. Indeed, the most recent Fed minutes emphasized that “no participants anticipated that it would be appropriate to begin reducing the federal funds rate target in 2023.” In their recent meeting, the ECB also expressed a hawkish tone, while the BoJ surprised markets with an early adjustment to their yield-curve control policy. Except for China, most EM central banks are also managing economies with above-target inflation and slowing growth. Overall, global monetary policy will likely remain tight this year, and consensus forecasters expect ‘mild’ recessions in the US and Europe.
China’s exit from zero-Covid policy should result in a more desynchronized cycle. Activity weakness may persist this quarter as infections remain high, but China should achieve 2023 growth closer to ~5% as the economy reopens and monetary policy remains relatively easy. Closely linked EM economies, such as ASEAN, should also benefit from increased Chinese activity. For example, Chinese tourism exports remain below pre-pandemic levels, while global commodity prices may see some support from greater mobility and demand from China. In addition, China is a large consumer of global semiconductors, which supports the Taiwanese and South Korean markets. However, the industry remains in a slowdown as global demand continues to weaken and inventories remain elevated.
Major geopolitical themes like the Russia-Ukraine war and the US-China rivalry remain relevant for EM equities. However, the risks (upside and downside) will vary by country and must be considered in current market pricing. In the case of the Russia-Ukraine war, energy prices rose last year in reaction to the events. Prices have since moderated, with India and China remaining large consumers of discounted Russian fuel. US-China trade tensions will continue to drive US supply chain readjustment towards ‘friend-shoring’ over a multi-year period. But China remains a large share of global exports, leaving major economies like the US and China closely intertwined for the foreseeable future.
Market Strategy: Relative to the previous quarter, global growth headwinds remain. But an earlier-than-expected China reopening should result in a more desynchronized cycle by mid-year. An obvious beneficiary has been the MSCI China index. Yet, valuations have already partially re-rated, and we continue to see longer-term structural growth drags preventing a more sustained recovery. Instead, we prefer to maintain our preference for other attractively valued EM Asian economies. In addition, we make the following three adjustments to the existing country allocations:
- We upgrade Saudi Arabia to overweight. Valuations have cheapened with the moderation in oil prices. We view this weakness as an attractive opportunity to build longer-term exposure.
- We upgrade Taiwan to overweight. The global semiconductor down cycle will continue to weigh on Taiwan and South Korea. However, Taiwanese valuations have cheapened to attractive levels on a forward P/E basis. A further de-escala- tion of geopolitical tensions would also be supportive.
- We downgrade South Africa to underweight. President Ramaphosa’s recent controversy is a distraction that reduces the likelihood of necessary structural reforms this year. Valuations have room to de-rate further.
EM Country Allocation
| Chg | -2 | -1 | 0 | +1 | +2 | |
| Asia | ||||||
| China | - | |||||
| South Korea | - | |||||
| Taiwan | ↑ | |||||
| Malaysia | - | |||||
| Indonesia | - | |||||
| Philippines | - | |||||
| Thailand | - | |||||
| Vietnam | - | |||||
| India | - | |||||
| Latin America | ||||||
| Brazil | - | |||||
| Mexico | - | |||||
| Europe, Middle East and Africa | ||||||
| Turkey | - | |||||
| Saudi Arabia | ↑ | |||||
| South Africa | ↓ | |||||
Note: Up/down arrows indicate a positive/negative change in our asset allocation compared to the previous quarterly outlook. A dash indicates no change.
Source: City of London Investment Management
*The publication reflects asset performance up to 30 December, 2022, and macro events and data releases up to 9 January, 2023, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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