The US central bank formalized the end of its easy money policy at its March meeting, forcing a significant repricing of the US Treasury curve, with the two-year duration seeing its most dramatic three-month rise since 1994. Russia’s war in Ukraine has entered its second month, putting outsized pressure on commodity costs, with oil, wheat and palladium prices posting their largest percentage price increases in a single quarter since the start. of the century.
This new economic and geopolitical reality is putting overall downward pressure on economic activity in emerging markets and upward pressure on inflation. At current commodity price levels, the pain inflicted on net importers already outweighs the gain to net exporters. And the sharp rise in energy and food prices will aggravate an already difficult inflationary context, given the large share of the consumer baskets that these goods make up in the emerging world. Although many emerging market central banks have taken early and aggressive action to control inflation, they are likely to be forced to tighten financial conditions further.
At the same time, making generic references to “emerging markets” in this context exposes investors to the risk of oversimplification. There is undoubtedly a significant transfer of wealth underway from commodity importers to commodity exporters, the latter being mainly located in the Middle East and Latin America.
In our analysis, this reality is not fully reflected in the markets. For example, we find an advantage in the bonds of oil and gas issuers given our positive view on energy prices, and we believe that Latin America offers a good range of attractive return opportunities. Furthermore, we believe that the continued reallocation of investors towards sustainable investments will support the demand for green, social and sustainability (GSS) bonds as well as sustainability-related bonds. Latin American rulers deserve recognition for their innovation in this area; Chile, for example, last month became the first sovereign state in the world to issue a sustainability bond.
More broadly, after a very painful start to the year, the outlook for emerging bonds at asset class level has improved markedly. In a base-case scenario, we expect USD-denominated bonds to generate high single-digit total returns through the end of the year, largely driven by aggregate returns of 6.4% and 5, 5% offered by sovereign bonds (EMBIG Div) and corporates (CEMBI Div), respectively.
The outlook for emerging market equities, meanwhile, remains intimately tied to the behavior of Chinese equities, which experienced a rollercoaster ride in March. A particularly strong selloff earlier this month was followed by a sudden rebound when Chinese Vice Premier Liu He addressed key market concerns in a speech on March 16. He stressed that the ongoing regulatory dynamic will become more transparent and predictable, that Chinese and American authorities are working on a plan regarding Chinese entities listed in the United States, and that China will continue to support companies seeking to list on the US. foreigner.
Building on these developments, we expect investors to gradually refocus on fundamentals and begin to appreciate the attractive valuations of Chinese equities. China’s earnings outlook for this year remains strong even in the face of COVID-related restrictions, and monetary and fiscal policy has shifted from headwind to tailwind. Overall, we think the positives should outweigh the negatives for Chinese equities, which should also help emerging market equities rally more broadly. We believe internet and e-commerce companies will outperform the broader MSCI EM benchmark, and environmental, social and governance (ESG) leaders should outperform as they help mitigate risk.
It has undoubtedly been a very difficult year, with difficulties that have spread to all asset classes and a series of known unknowns weighing on investors’ risk appetite. Will the Fed be able to dampen inflation without pushing the US economy into recession? How long will the war in Ukraine last and what impact will it have on commodity prices? Will China’s aggressive zero COVID policy become a drag on economic activity in the face of new outbreaks? Will soaring food prices trigger social unrest in vulnerable countries?
As we try to gain more visibility around these areas, one thing is clear to us: investors who stay engaged in the markets according to a strategic plan, and who are ready to seize tactical opportunities along the way, are likely to do better than those drastically reduce risk in the face of uncertainty hoping for a better entry point.
The content is a product of the Chief Investment Office (CIO).
Main Contributor: Alejo Czerwonko, Chief Investment Officer Emerging Markets Americas
Original Report – Emerging Markets and the Two Wars, April 4, 2022.