There’s no two ways about it, it’s been a tough year for emerging markets (EMs). Tighter monetary policy globally — a byproduct of a high-inflation environment — has been a headwind. So, too, has the ongoing war in Ukraine and the subsequent economic sanctions on Russia. But to be fair, nothing on the equity side has had a banner year thus far — developed markets have fallen in tandem with EMs.

But in spite of a challenging recent past, and the prospect of potential economic downturns on the horizon, we believe that there’s a strong longer-term opportunity in EMs. Prudent investors may benefit from keeping an eye on the possibility of a brighter EM horizon, rather than focusing solely on the present gloom.

Counter-cyclical China

Inflation has run rampant in developed and emerging markets alike, but not in China. The rate of inflation in China is well below the global average, so much so that even if it ticks up, there won’t be cause for concern (Charts 1 and 2). China represents 35% of the MSCI Emerging Markets Index, a proxy for EMs, so the fact that it lacks the single-largest issue plaguing the rest of its index peers shouldn’t be underestimated.

What’s more, China has announced more than RMB 1 trillion (~$146 billion) in funds to prop up consumption and investment as well as aid the real estate sector. And the People’s Bank of China has cut key lending rates to boost liquidity.

This all speaks to the fact that China is one of the few places in the world where there is real counter-cyclical opportunity. Every other market, emerging or developed, is on a tightening path.

Of course, China hasn’t had an incredible year to date, either. But the issues China has been contending with are unique and we have reason to believe that these issues could be resolving.

Growth in China has struggled amid, among other factors, its stringent zero-Covid policy, which has seen harsh lockdowns imposed on major centers of commerce, such as Shanghai, this year. But China is aware of these issues and knows that its own policies are at least partly to blame. As this year has progressed, China has adopted a more dynamic zero-Covid policy that’s less disruptive, and while some cities are still in lockdown, this bodes well for the growth outlook.

Plus, the Covid-19-related outlook is improving in China. Infections are at a relatively low rate and vaccination rates are rising, sparking hope that the worst of Covid and lockdowns may be behind China for the year.

Another issue that’s dampened Chinese equity market performance of late is the regulatory environment. Last year, a series of high-profile regulatory interventions rocked Chinese financial markets, especially in the technology and education sectors. Lately, the government rhetoric has improved, particularly within the platform, e-commerce and gaming spaces. And Chinese officials have indicated that going forward, they won’t impose market-moving regulations without providing advanced notice. This is a hopeful signal for the wider regulatory outlook.

Another area of the market that’s been under scrutiny in China has been real estate. In response to turbulence in this sector, there have been mortgage boycotts, but we don’t think that these are a huge cause for concern at this time. The affected mortgage payments comprise an exceptionally small percentage of the Chinese banking industry’s total loan book.

Plus, there have already been more than three stages of intervention to deal with the situation and make more liquidity available to property developers so that they can complete unfinished projects.

Ultimately, we think that China has the leg room to take the necessary measures to prevent the issue from engulfing more housing projects.

We have even more reason to be optimistic about the outlook for China when we consider that its 20th National Congress is approaching. The Congress, which will take place in October, has generated some uncertainty, which, of course, markets don’t like. But once the event itself is in the rearview, we suspect that some of that uncertainty could shake loose from the market.

Stimulus, the possibility of easing Covid restricts, potential regulatory relaxation and putting this Congress behind us all inspire optimism about China, which, in turn, could suggest a brighter outlook for EMs as a whole as well as compelling investment opportunities.

Commodities could support EMs

EMs are home to many companies that produce, process and/or distribute commodities. While we certainly don’t hope for inflation to rise even more, several EM countries could benefit from higher commodities prices.

There are a few considerations at play here. For one, while the humanitarian toll of the Russia-Ukraine war can’t and shouldn’t be forgotten or underestimated, a byproduct of the unfortunate (to put it lightly) situation in Ukraine is opportunity elsewhere.

Brazil, for example, has been a beneficiary of higher commodity prices. It’s reported record grain supplies and may experience an uptick in exports. Opportunities like these exist across many emerging markets. Rising commodity prices could positively impact mining companies in South America, for instance. In southeast Asia, Thailand is starting to experience improved tourism as Covid restrictions and concerns ease. Thailand is also home to oil and gas production companies, for example, that could benefit from elevated oil prices.

Higher oil and gas prices have also accelerated the shift toward renewable energy, signaling potentially significant opportunity in this space. Many different commodities are critical components of renewable infrastructure, and there are several well-established companies in emerging markets that are involved in renewables production at all different parts of the supply chain.

These countries are subject to many of the same challenging inflationary pressures as their developed market peers, but many have already taken action in the form of higher interest rates. There’s a proactive approach to the problem, which could help improve the outlook.

Even if the US sneezes, EMs may not catch a cold

As the old saying goes, when the US sneezes, the rest of the world catches a cold. And, of course, the very real probability that the world’s largest economy will tip into recession could have negative impacts on the global equity outlook. However, we still hold a sanguine view of EMs.

US recession may not ripple out to EMs. Many EM central banks have already introduced interest-rate hikes, so there’s no need for them to march in lockstep with the US Federal Reserve. In fact, EMs are reaching the peak of their own tightening cycles. What’s more, EM currencies have held up relatively well against the US dollar, even as it’s increased in strength.

As a result, we don’t think it’s likely that EMs will scramble in the face of US recession, which is a positive for the EM outlook. In this instance, EMs may be more insulated from US recession than they’ve been in past times of crisis, like the onset of the Covid-19 pandemic or the Global Financial crisis.

In our view, this dynamic may actually suggest opportunity for EMs, which could represent a diversifying equity investment options for investors concerned about the possibility of a looming US recession. Beyond this, EM balance sheets are strong and EM valuations are deeply discounted compared to their developed market peers, based on historical averages.

General EM optimism, particular opportunities

Equity markets have underperformed in 2022 thus far. While some uncertainty lingers, we believe that some of the darkest days may be behind us and see bright spots on the EM horizon. Right now, valuations are attractive and we believe that, among EM companies, those with high-quality characteristics, such as strong balance sheets, competitive costs and stickier customer bases, could represent the most compelling investment opportunities. Despite current equity market malaise, there are strong fundamentals among EMs and several themes that support longer-term promise.

IMPORTANT INFORMATION

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.

Trading in commodities entails a substantial risk of loss. Commodities generally are volatile and are not suitable for all investors. The commodities markets and the prices of various commodities may fluctuate widely based on a variety of factors.

Projections are offered as opinion and are not reflective of potential performance. Projections are not guaranteed and actual events or results may differ materially.

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