The uncertainties of the pandemic, rising inflation and slower growth in China all resulted in a bumpy ride for emerging market investors in 2021.
At the end of the year the MSCI Emerging Markets Index was down 2.5%, underperforming the developed markets MSCI World Index by a whopping 24% with Turkey, China and Peru the biggest underperformers.
Like most parts of the world, emerging market valuations are not cheap relative to history, but they are nowhere near as expensive as the likes of the US.
Tackling the Covid recovery and inflationary climate
I won’t bore you with the uncertainties of Covid – we are all aware of the threat of new variants like Omicron and the potential for further lockdowns. However, many emerging market states are now catching up with the developed world in terms of their vaccine rollouts – for example at least 80% of people in the UAE, Chile and China are at least partly vaccinated.
As pent-up demand fades following the global re-opening trade, there are expectations that emerging market growth will slow to 4.4% this year, compared to 6% in 2021. However, as a recent JP Morgan outlook note indicates, it will remain above its 2015-2019 trend.
The ‘transitory or not?’ question over inflation is one that emerging economies arguably have to be even more attentive to than those in developed economies. The sharp spike in emerging market inflation hampered many economies in 2021 and forced the likes of Russia, Hungary, Mexico, Colombia, Brazil and Poland (amongst others) to raise interest rates.
Simply put, banks in these economies had to jump the gun rather than hope that price rises and supply bottlenecks were temporary. In some countries, inflation has risen sharply simply because food accounts for a larger portion of production – in a nutshell central banks have to work harder to manage price rises.
In its October 2021 World Economic Outlook, the International Monetary Fund forecasted inflation would hit 6.8% in emerging and developed economies, before falling to about 4% by the middle of this year.
The threat of stimulus being withdrawn hangs large, particularly amid fears of stagflation.
Schroders head of emerging market equities, Tom Watson, says that while anticipation of tighter monetary conditions has put upward pressure on the US dollar – which is a headwind for emerging world financial conditions – emerging markets are more resilient when compared to the last time the Fed hiked rates in 2013.
Individual challenges
Naturally, China continues to play a major role for emerging markets. Much has been made of the regulatory tightening across numerous sectors last year and the subsequent slowdown. Chinese officials have begun to try and remedy this – for example in December 2021, the People’s Bank of China reduced the reserve requirement ratio by 0.5% , releasing almost $200bn of liquidity.
Russia has its own geopolitical challenges with the likes of the Nord Stream 2 pipeline between the North Sea and Germany and its ongoing issues with Ukraine; meanwhile Brazil slipped into recession in the third quarter of last year courtesy of supply chain disruptions, and heightened inflation.
Gone are the days when emerging markets have to be considered as a bloc-type investment. The move from a commodity to a consumer society has also implemented significant change too – with tech become a growing part of the economy. Ultimately, investor fortunes in the past two years have depended on whether you’ve held India and China at the right time (China in 2020 and India in 2021). Looking forward it seems to be more of a stock pickers’ market, with volatility and opportunity going hand in hand.
Investors may want to consider the likes of the FSSA Global Emerging Markets Focus fund, a portfolio of 40-45 large and medium-sized companies. Managed by Rasmus Nemmoe, the focus is on companies with strong competitive advantages, defensive balance sheets, attractive growth opportunities and solid management teams that should help deliver 14-15% annualised earnings and free cash flow over the medium to long-term. Another portfolio worth considering is the Federated Hermes Global Emerging Market SMID Equity fund, which looks further down the market-cap scale.
It is also worth noting the shift in style performance last year – with value stocks returning 4% compared to an 8% fall for emerging market growth stocks. Those who believe this change has legs might consider the Magna Emerging Markets Dividend fund, a 40-55 stock portfolio offering exposure to emerging market companies that pay higher than average dividends. The portfolio has a value profile because it won’t own some of the big tech names as they do not pay an income.
The last area I’d look to is India – a strong outperformer in 2021. The long-term trends are overwhelmingly favourable given more than 50% of the population is under 25 years of age, with 1 million new people entering the workforce each month. Those demographics are impossible to ignore in terms of future growth, particularly when you add in the infrastructure drive and the rise of the middle class. A good starting point here would be the Goldman Sachs India Equity fund, which is an ‘all weather’ vehicle managed by Hiren Dasani.
Darius McDermott is managing director of Chelsea Financial Services and FundCalibre. The views expressed above are his own and should not be taken as investment advice.