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Emerging Markets Quarterly Outlook

October 2022*

Facing a Synchronized Slowdown

The backdrop for emerging markets has become more challenging amidst a slide into recession in developed markets, softening Chinese growth, tighter financing conditions and a strong US dollar. Outside of China, many economies have remained resilient, but the headwinds are multiplying.

Emerging market (EM) equities dramatically underperformed their developed market (DM) equivalent during Q3, even though both markets incurred losses. But EM losses of 11.6% during the quarter amounted to almost double the 6.2% loss recorded by DMs. This took place against a backdrop of rapidly rising US rate expectations as the notion that inflation had peaked in May/June began to wane and the Fed’s hawkish rhetoric found increasing market acceptance. The market expectation for the terminal Federal Funds rate rose from 3.5% to 4.5% over the period, while the expected date of the rate peak receded from May to March 2023.

Indeed several (interlinked) drivers that usually propel growth and returns in different parts of the EM asset class do not augur well at this stage. First, Chinese growth is slowing and, together with rising tensions surrounding its claim on Taiwan has led to a 31.2% loss year to date, underperformance against the EM MSCI Index by 4.1% points. This matters both for the index performance per se, as China constitutes a still hefty 31.4%, and it matters for other EM economies given China’s role as a source of final demand (for Asia), as part of a regional supply chain and as a voracious consumer of raw materials (for Latin America). Secondly, DM economies are undergoing a highly unusual synchronized and sharp tightening cycle, which, together with the energy crisis, will likely lead them into an equally synchronized recession. This closes off a key source of demand for EM exports, in many cases a pivotal growth factor. In addition, the associated strength of the US dollar brings its own challenges for export-oriented/foreign currency indebted EMs. Finally, as the global economy exits pandemic-related restrictions, demand for work-from-home equipment is easing, just as the tech sector in Asia is bringing new supply online and accumulating inventory. A third potential driver of EM growth is domestic demand on the back of rising private consumption. However, prospects there have also darkened as many EMs experienced populist challenges to the policies proposed by the erstwhile “Washington Consensus” which conflict with the objective of sustainable, long-term growth.

Yet, leaving China and the US aside, the resilience of some emerging markets this year has been remarkable. EM stocks typically behave as a leveraged version of DM stocks and as a result sell off relative to their DM peers in times of crisis (e.g. during the 2008 GFC, the 2013 ’taper tantrum’, the 2015 China FX devaluation and the 2020 Covid pandemic). But the current crisis affects DM specifically, through monetary tightening in the US and the energy shock in Europe in particular. By contrast, emerging markets countered the inflation shock earlier, partly due to their historical experience with the effects of even transitory supply shocks and partly because of the lower credibility of their central banks. Brazil for example, started its tightening cycle a full year before the Fed. Thus, EMs have already partly absorbed part of the effect of tighter domestic financial conditions. In addition, they have benefited from the elevated level of commodity prices. In turn, a basket of EM currencies has outperformed a G10 ex. US basket since January 2021.

Market Strategy: Relative to the previous quarter, inflation has again proven to be more persistent than anticipated, actual and expected rates have moved up sharply and the odds of a recession have therefore risen. While some EMs have remained resilient, the challenges are now multiplying and, in addition, fears of an ‘accidental’ financial crisis are spreading. As such, they may yet follow their well-trodden path of previous global crises. We thus keep our existing country allocation and only make the following two adjustments:

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 September, 2022, and macro events and data releases up to 11 October, 2022, unless indicated otherwise.

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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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© 2022 City of London Investment Management Company Limited.
All rights reserved.

City of London Investment Management Company Limited (“CLIM”) is authorised and regulated for the conduct of investment business within the UK by the Financial Conduct Authority (FCA) and is registered as an Investment Advisor with the United States Securities and Exchange Commission (SEC). Registered in England and Wales No. 2851236. Registered Office: 77 Gracechurch Street, London, EC3V 0AS, England.

© 2022 City of London Investment Management Company Limited. All rights reserved.