Outlook 2022: Emerging markets

As we head into 2022, it is very encouraging that the rate of vaccinations in emerging markets (EM) has seen a marked acceleration. This has helped support economic growth, but an encore is unlikely in 2022.

The fact that headline EM growth is set to moderate is well understood by markets though, which have adjusted accordingly through 2021. Indeed, there is potential that EM can provide a positive surprise this year.

Emerging market economies

David Rees, Senior Emerging Markets Economist

The impact of new variants presents an ongoing risk to be aware of, as the uncertainty in relation to Omicron illustrates, and these could change the outlook quite dramatically. The vast majority of EM are on track to inoculate large proportions of their population in the coming months though. This should be clearly beneficial with respect to ongoing recovery in economic activity.

However, there is no getting away from the fact that EM economic growth will be slower in 2022. Many of the economies have already recovered to pre-pandemic levels, and this naturally makes it harder to sustain above-trend rates of growth. For 2021, growth has been flattered by the low base comparison in 2020, and this almost guarantees slower rates of expansion in 2022. Delving beyond these technicalities, there are some more fundamental reasons to expect growth to slow.

Downgrades to our developed market growth projections mean that demand for manufactured goods is likely to soften during the course of this year. Global trade is an important driver of EM growth and while further post-pandemic restocking by companies may provide near term support, the stellar rates of export growth seen during 2021 are unlikely to be sustained. This is likely to be negative for small, open EM economies across Asia, in parts of Central and Eastern Europe along with Mexico.

The China outlook is likely to have implications for certain EM. For example, if subdued real estate sector activity leads to softer demand for commodities such as industrial metals, this would hit the exports of economies in Latin America and Sub-Saharan Africa.

Within EM, tighter monetary and fiscal policy will increasingly weigh on growth. The sharp increase in EM inflation, which stifled many EM in 2021 and forced central banks into relatively aggressive interest rate hikes, should subside. However, higher rates typically weigh on activity with a lag of six to nine months. Combined with the possibility of some fiscal retrenchment, as governments attempt to repair the damage to budget positions caused by the pandemic, tighter policy is likely to be a significant drag on activity. That may ultimately mean central banks do not deliver all of the tightening that is priced into markets, opening up a window of opportunity for investors in local markets.

The upshot is that we expect EM GDP growth to slow from an expected 6.5% in 2021, to around 4.5% in 2022. If we are right, then EM growth is unlikely to outpace that in some developed markets. And while that should not be a complete surprise to investors, such a narrow growth premium has typically set a tricky backdrop for markets.

Emerging market equities

Tom Wilson, Head of Emerging Market Equities

The global stimulus in response to the pandemic is now fading with liquidity growth falling away and the US taper imminent. Anticipation of tighter monetary conditions has put upward pressure on the US dollar which is a headwind for emerging world financial conditions. Bottlenecks, labour market disruption, energy price rises, and economic catch up post-Covid have also created more persistent inflation than anticipated, which has been driving stagflation fears.

There has been ongoing normalisation globally, underpinned by vaccine distribution, as well as high levels of post-infection immunity. Vaccine penetration in EM has been catching up with developed markets. In general, this should result in fewer future restrictions on activity, enabling bottlenecks to be addressed and reducing disruption to manufacturing and logistics in 2022.

Meanwhile, the withdrawal of stimulus and fading pent-up demand may see inflation pressures ease, and should calm stagflation fears. Of course, new variants pose an ongoing risk, especially if these evade existing vaccines and lead to higher mortality rates, and could materially change the outlook. 

Policy tightening from the Fed may be an ongoing headwind, but EM are more resilient when compared to the last Fed hiking cycle. External accounts are typically in good shape, recent capital inflow has been less “hot” than in 2013, EM currencies are generally looking cheap, and the yields on EM local debt are relatively attractive.   

The reduced availability of credit in China is being felt. Economic conditions are challenging due to a negative credit impulse, the 12-month change in new lending as a share of GDP, and broad based regulatory action. The latter has created uncertainty for the market and had direct economic impact via the real estate sector. We expect policy to become more stimulative and the credit impulse to trough and recover.

The credit impulse normally impacts economic activity with a nine month lag, as the chart below shows, suggesting that the Chinese economy will remain weak until the middle of this year. However, in the second half of 2022, there is potential for the macroeconomic outlook in China to improve. Although corporate profits will be impacted by last year’s growth slowdown, markets are forward looking and may begin to factor in a recovery.

Valuations

In aggregate, EM valuations are not cheap relative to history. However, this masks considerable variations in terms of country, sector, stock and investment style. There is also some uncertainty over company earnings next year, stemming from economic growth pressures, fed by monetary policy tightening. Valuations when compared to the US, however, look more attractive, while various EM currencies are looking increasingly cheap.  

Moving through 2022, we may begin to see a more positive backdrop. Monetary policy has anticipated higher inflation, and real rates look attractive. Should inflationary pressure ease, this could provide scope for monetary easing. Meanwhile, there is potential that China’s economy could begin to improve.

Emerging market debt

James Barrineau, Head of Global EMD Strategy

The Fed’s official launch of the bond tapering programme is an appropriate coda to a year when emerging market debt (EMD) investors struggled mightily with flashbacks from the 2013 taper tantrum. This time around, we don’t think investors are looking at a 2013-2015-like two lean years as the Fed follows a similar format.

The dollar is 18% higher than it was at the start of the previous cycle. EM central banks have been pre-emptively hiking for many months, widening the nominal rates difference with the developed world. And currencies have, by and large, never fully regained their real valuation levels from before the first tapering cycle. Valuations are much brighter this time around.

If inflation moderates and returns close to central bank target levels in 2022, then the outlook for local currency EMD investors could be very bright.

The most highly credible central banks, such as Russia and Mexico, will likely be the first to tap the brakes on hikes. Asian countries are closer to developed market credibility than other EM regions and while local yields are lower, currency volatility is also much more subdued. Over the course of 2022, we expect virtually the entire asset class to have completed hiking cycles and be left with real interest rates well above developed counterparts, perhaps with rate cutting cycles coming into view.

Currencies will have to co-operate with a bullish rates view for most investors to be lured into investing. The stability of China’s renminbi, where real rates – that is net of inflation - are the most positive in the asset class, signals that positive rates are a powerful lure despite significant sovereign issues.

On the dollar debt side, the prospects are less bright. In investment grade EM debt the yield spread to US Treasuries is historically low, yet still offers a modest pick-up to similarly rated developed debt which has anchored stability. High yield EM bond spreads are more attractive than US high yield but lack the stable operating environment. Being active and taking a selective approach is key. Some lower rated credits will struggle with funding requirements and the need for fiscal tightening (many sub-Saharan and frontier countries). Others might not be default candidates but will struggle with the politics of regaining debt sustainability as both growth and spending slows.