Emerging Markets - What will 2022 bring
The MSCI Emerging Markets Index ended the third quarter down 8.1%, the worst quarter since the first quarter of 2020 when COVID-19 began to spread around the world.
Negative returns in the quarter were due in large part to the sell-off in Chinese equities, a combination of ongoing regulatory announcements, concerns over the liquidity and debt restructuring of Evergrande, China's second-largest property developer, and electricity shortages. The consumer discretionary, communication services, real estate, and health care sectors, all of which have a large proportion of Chinese equities, underperformed the index. Energy, utilities and financials led the way and were the only sectors to finish in positive territory over the period.
The US is not alone in experiencing a deceleration in growth. After leading the global growth recovery in 2020, China's growth has been slower than expected in 2021. However, despite slowing momentum, developed markets growth forecasts remain solid for 2022 and policymakers in core economies seem keen to avoid any premature tightening.
We believe that most of the weak US economic data is in the rearview mirror and our base case remains that the Fed will announce its taper plans in November and likely commence trimming bond purchases by $15 billion per month in December. Thus far, the Fed has been highly transparent, and both the timing and pace of tapering seem well anticipated and priced in at this juncture. In its statement following its meeting in late September, the Fed noted, "If progress continues broadly as expected, the [Federal Open Market] Committee judges that a moderation in the pace of asset purchases may soon be warranted.” Thus, we do not expect the announcement or implementation of tapering to derail the recovery in emerging markets. Meanwhile, rate hikes remain a long way off. To the extent that long-term Treasury yields drift higher as Fed normalization commences, we expect only modest moves. More importantly, we expect such moves to be a result of better growth prospects rather than inflationary concerns. We believe this points to an environment of low volatility and outperformance of risk assets. Also, in contrast to 2013, most of the major emerging markets countries—Brazil, China, South Africa, Mexico, and Russia, among others—are now running current account surpluses and are therefore less dependent on portfolio flows.
While the headwinds from these two key risks have faded, a new risk to emerging markets assets has recently surfaced. Toward the end of the third quarter, risks from the Chinese property sector grabbed the spotlight. Media attention has focused on the highly levered property developer, Evergrande, becoming one of China's largest restructurings. Fears of contagion have caused credit concerns in the Chinese property sector and have led to volatility in global and emerging markets asset markets. We think such fears are overblown and see limited knock-on effects for emerging markets debt assets broadly. The risk of further slowing in the Chinese property sector are real; however, what matters most for the broader asset class is how policymakers in China handle the situation and the potential negative impact on Chinese growth, and by extension, commodity prices.
All in all, we believe this backdrop paves the way for emerging markets debt to continue on the road to recovery. Credit—both sovereign and corporates, particularly in high yield—should perform well in an environment of stable Treasury rates and spreads that remain wide relative to history and fundamentals. Additionally, commodity prices should remain elevated as demand rebounds, thereby improving the terms of trade for commodity exporters. Thus, we remain overweight credit and have been incrementally adding to positions.
In local debt, the outlook for currencies also remains positive, but our level of conviction is lower, and the downside risks are greater. Valuations remain attractive, financial conditions are accommodative, commodity prices remain elevated, and emerging markets central banks have turned more hawkish, ensuring that real yields remain attractive relative to developed markets. However, growth is the missing ingredient that must return if emerging markets currencies are to deliver sustainable outperformance. Specifically, the growth differential between emerging and developed markets needs to shift in favour of emerging markets. For that to happen, vaccination rates must continue to improve, and policymakers in emerging markets must make sound, orthodox policy choices. Neither outcome is a certainty; thus, we believe conservative positioning in currencies is warranted. However, we expect to begin adding exposure in the coming months should we begin to see sufficient evidence of an emerging markets growth rebound. We continue to generally underweight or avoid local rates exposure because several central banks are in the midst of normalizing policy rates.
In short, we continue to be highly selective among both the different segments of the market and individual countries, as we believe differentiation will be key to capturing returns and mitigating risk in this environment.
