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At 632 days (since 17 February 2021), this is now the longest emerging markets (EM) equity bear market on record. Despite this, we believe liquidity and growth headwinds are likely to persist into next year. In this short article, we explore three key considerations for EM investors in today’s challenging environment and highlight potential winners and losers in 2023.
Though we think the US Federal Reserve’s (Fed’s) near-term rate hikes are priced into the market, the terminal rate is likely not. The US cycle is indeed slowing but not enough for the Fed to pause hiking rates, and the US dollar is now at close to a 20-year peak relative to other G7 currencies. In Figure 1, we show EM equity’s historical performance (relative to global markets) as the dollar changes value. Our leading indicators suggest overall global liquidity conditions will likely continue to tighten for another six months, with two notable EM exceptions: China and Brazil. China has been loosening slowly since the beginning of the year, with negligible impact, while Brazil may start in the second quarter of 2023.
These liquidity conditions are important to note because today’s bear market is not an “EM crisis.” It is a developed market crisis that is impacting EMs. Notably, EM sovereigns are still in relatively healthy shape, especially compared to previous tightening cycles. However, liquidity drives markets and select EMs will be tested again as this environment persists. US rates are moving to unprecedented levels for this asset class (which started to become investable in the early 1990s) and more fragilities will likely surface in 2023 as a result.
Looking to the year ahead, we are closely monitoring the foreign exchange reserves of countries with net energy trade deficits, such as India, South Korea, and the Philippines. The more the US dollar appreciates, the more these countries’ central banks (and many others) may need to tighten and could face increasingly challenging trade-off decisions between inflation and growth.
But not all emerging markets are equally vulnerable to today’s environment. Brazil and Mexico, for example, with their ties to commodities and the US economy, respectively, could be near-term relative winners. We believe that inflation is well past its peak in these countries, that neither must govern through a Russia/Ukraine war spillover, and that both are largely removed from the specter of China’s influence.
Critically, when the US dollar and tighter liquidity conditions finally pivot, so, too, will emerging markets overall, in our view. But could China continue to lag after such an inflection point? We think so, but this will depend on the trajectory of its great-power geopolitical struggle with the US. The latest policies from Washington seeking to end China’s development of high-end chip manufacturing — combined with recent political developments in China — do not bode well for a potential truce next year.
Until that US-dollar pivot and the emergence of a more favorable environment for broader emerging markets, we believe investors should look to take advantage of the wide dispersion across EM countries next year. In our view, it will be critical to focus on the markets that can still thrive in a world with higher inflation, rising rates, and heightened tensions from deglobalization.
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