Outlook 2023: Emerging markets

Emerging market economies

There are at least three reasons to think that emerging market economic growth will slow in 2023.

First, our expectation that the US will follow the eurozone and UK into recession means that global demand for goods is likely to soften. That will be a particular threat to small, open economies in Asia, Central and Eastern Europe (CEE) and Mexico that rely on exports to drive growth.

Second, while the reopening of China’s economy may lend support to demand for natural resources, slower global growth is likely to weigh on commodity prices. At the very least, this suggests that commodity-exporting emerging markets (EMs) are unlikely to see the boosts to their terms of trade that are generally needed to drive growth. And there is a risk that this driver will go into reverse.

Third, tighter domestic economic policy will increasingly weigh on growth. Fiscal policy is generally tightening as governments look to repair the damage done to public finances during the outbreak of Covid-19, while the lagged impact of previous large interest rate hikes will also sap demand. Deteriorating balance of payments positions mean that rates may need to rise further in parts of Asia and CEE if global financial conditions continue to tighten.

The good news, however, is that EM inflation is around its peak and should start to fall back during the course of 2023. The impact of sharp increases in commodity prices since the Russia-Ukraine conflict in early 2022 will start to reverse as base effects in food and energy inflation become more favourable. A combination of tighter policy and slower growth will ultimately ease core pressures.

Easing inflation will start to relieve pressure on real incomes and probably allow some central banks, notably in Latin America, to begin lowering interest rates again in the second half of 2023, setting up a cyclical recovery as we head into 2024.

Emerging market equities

There are four potential supports for emerging equity markets in 2023:

- Move into an endemic Covid policy in China

- Global disinflation

- US dollar stabilisation or depreciation

- Valuations that now price weak near-term earnings expectations

China: potential for rebound

China may see a cyclical recovery. The economy has been under pressure against a backdrop of zero-Covid policy and stress in the real estate sector. China now appears to be moving to an endemic approach to managing the virus. New domestically delivered vaccines support a renewed push on vaccine penetration. A move to an endemic state will significantly reduce the risk of persistent macro pressure.

In terms of the real estate sector, prior tightening in combination with a regulatory clampdown on developer leverage (debt) led to a crisis of confidence and a marked downturn in sales in 2022. This is not easy to fix but the authorities are incrementally adding policy support.

Headwinds remain: global growth will weigh on export performance in 2023. However, consumption and real estate are now at a low base and an endemic Covid policy is giving the market greater confidence in a cyclical rebound.

Disinflation could drive US dollar weakness

We expect global disinflation through 2023. As rising interest rates in EMs meet this disinflation, improving real (or inflation-adjusted) interest rates will provide greater support for emerging currencies, which look broadly cheap. The US dollar’s real effective exchange rate (REER) - i.e. its value compared to a weighted average of several other currencies - is expensive versus history and may continue to soften if conviction rises that the Federal Reserve (Fed) is moving successfully to re-anchor inflation and Fed expectations have peaked. A softer US dollar should allow EM currencies to recover, alleviating pressure on EM central banks and financial conditions.

Valuations are relatively cheap

The global growth outlook for 2023 is poor and questions remain as to the path of inflation and interest rates. However, valuations reflect a more difficult earnings outlook. Uncertainty and short-term earnings stress can present investment opportunities. We have begun to deploy cash into stocks where we believe valuations now offer attractive entry points. In particular, we have been adding back to technology companies in South Korea and Taiwan that offer good structural growth. Equity valuations are broadly cheap versus history and an EM currency recovery would enhance returns for US dollar investors.

The coming months may provide opportunities

The economic outlook for 2023 is weak and uncertainty and volatility may remain elevated in the near term. Valuations have improved, earnings expectations have been resetting and currencies are broadly cheap. 2023 may bring a peak in the monetary cycle and 2024 may bring better economic conditions. Investors should continue to look for opportunities to add exposure in coming months.