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3 Compelling Reasons Investors Should Embrace Emerging Markets

Emerging market stocks have been overlooked by investors for most of 2022 & this year, but it’s time to take notice as this undervalued asset class could make a come back in the second half of 2023.

Emerging markets (EM) have experienced a more turbulent ride than the already volatile U.S. stock and bond markets over the past 2 years. Currently, EM stocks are enduring one of their longest bear markets, with the MSCI Emerging Markets Index down approximately 40% from its peak in February 2021.

The primary catalyst for this poor performance can be attributed to China and its regulatory crackdowns on global technology franchises, restrictions on debt restructuring among homebuilders, and a zero-COVID policy that has led to rolling lockdowns and disrupted economic momentum. These factors have resulted in disappointing growth. Since China is a crucial trading partner for most other EM regions and accounts for a significant portion of the market capitalization in most EM benchmark indices, its fate weighs heavily on investor sentiment toward EM.

Global inflation in oil and food prices, coupled with the strength of the U.S. dollar, has further exacerbated the challenges faced by emerging markets. The robust dollar increases the cost of dollar-denominated debt and imports for these markets.

Consequently, global investors have significantly reduced their EM positions and have avoided the asset class altogether, leading to historically low valuations. The MSCI EM Index now trades at approximately 10 times forward earnings estimates, while the MSCI China Index trades at around eight times. In contrast, the S&P 500 Index still maintains a forward price-to-earnings ratio of 17 and continues to be heavily owned by investors worldwide.

However, there are potential factors that could signal a positive turnaround for emerging markets:

– A more pro-growth and stimulus-oriented approach in China: Economists at Morgan Stanley believe that China will prioritize economic development over security and social stability concerns that have been at the forefront for the past two years. Furthermore, it is anticipated that China’s zero-COVID policy coming to an end could mean a substantial rebound in private consumption and boosting China’s inflation-adjusted GDP growth from below 3% to 4.5% in 2023. Importantly, China’s response to COVID has differed from that of most Western countries, resulting in lower inflation and interest rates, which provides ample room for stimulus measures.

– A potential peak in the strength of the U.S. dollar: As the Federal Reserve’s rate-hiking cycle matures and economic growth outside the U.S. improves relative to that of the U.S., the dollar may lose momentum. A potential weakening of the dollar could benefit EM countries through the appreciation of their own currencies. Additionally, commodity-exporting nations, particularly those in Latin America, may experience stronger commodity prices due to increased global demand.

– Shifting global trade relationships: While U.S.-China relations remain complex, the reconfiguration of strategic supply chains could create new opportunities for EM nations other than China. Notably, in sectors such as consumer and industrial goods, new relationships between the U.S. and countries like India, Latin America, and non-China-linked countries in Southeast Asia are anticipated. Meanwhile, China is expected to continue pursuing economic integration with these same countries, extending efforts that were initially fostered through its Belt and Road infrastructure program.

These catalysts point to a potential rebound in emerging market equities in the second half of 2023. In our analysis, emerging market (EM) equities have an asymmetric return profile in 2023. While there is a potential for limited negative impact from various known factors such as inflation, geopolitical tensions, and Chinese growth, the markets are poised to experience substantial gains in the face of positive news.

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