Q1 2022 CIO Review and Outlook

It might seem at first that everything is against emerging markets. The dollar is strengthening and long bond yields are falling as two-year bond yields rise, causing the yield curve briefly to invert—a sign of a central bank squeezing excesses out of an economy. Added to this, the 30-year mortgage rate has soared recently. That will hit the housing market. And fiscal policy, too, has turned tight, which may hit consumption.

None of this bodes well for the U.S. economy in the short term—recession is possible, even likely. The tensions between the U.S. and China continue and have been exacerbated by Russia’s invasion of the Ukraine. Indeed, it is an extremely difficult backdrop for emerging markets in general.

Unsurprisingly, valuations have correspondingly fallen and that gives us a meagre degree of comfort. However, more comforting is the fact that emerging markets have only marginally underperformed the S&P 500 year to date despite the weakness in China and the extreme losses in Russia. Indeed, equities seem relatively calm about all of these events. Partly, I am sure, this reflects the market’s continued belief that inflation will start to cool—for inflation expectations, although they have risen, remain high for the short-term only. So, the market, on average, still believes that supply-chain issues and possibly labor shortages and labor mismatches are largely the cause of higher prices and will be rectified within 12 months. Partly, too, though, it seems that emerging markets on average may be far more resilient to external shocks in this downturn than their reputation suggests.

Strength in Brazil

Let’s take Latin America to begin with. These markets have performed quite strongly, particularly the major market of Brazil. It’s tempting to put this down to the performance of resource stocks—and they have certainly played a part as commodity prices have risen both with the general inflationary environment and with a fear of shortages after sanctions were imposed on Russia. These are commodity-producing countries and so they tend to do well at times like this. However, over the past quarter, other sectors have performed just as well—notably financials. And some sectors, particularly in the service sectors, have performed even better.

So, the recovery in Latin American markets has been far more broad than just commodities. That is perhaps partly because they lagged Asia’s markets for much of the COVID-19 lockdowns and so the rally, as abrupt and as broad as it has been, has not extended valuations too much and indeed, in general Latin America still trades at a discount to Asia. Of all the Latin American economies, perhaps at this moment Mexico is best placed for long-term sustainable growth. In recent years, Mexico has done much to strengthen its macro economy and its position close to the U.S. will continue to be advantageous in the shifting of global supply chains.