Market volatility has jumped in recent weeks. Strength in U.S. employment and inflation data has brought weakness to global equities as markets anticipate the Federal Reserve will keep rates higher for longer. We believe investors should use this volatility and future bouts of weakness to add emerging markets to their portfolio. Here’s why.
- Emerging markets can be defensive
Decoupling of emerging markets from the U.S. and developed markets can and typically does happen when the right conditions exist.
- The correlation of emerging markets versus the S&P 500 Index reached a four-year low in 2022 and Chinese equities correlations with the S&P 500 are close to 20-year lows 1
- Today, major emerging economies are on very different trajectories than those in developed economies largely because of their prior monetary tightening cycles and the easing of COVID restrictions in China
- We expect emerging markets to outperform U.S. markets if U.S. inflation and interest rates remain higher for longer
- China: Why it’s not too late
Outperformance of Chinese equities versus the S&P 500 since October 2022 has been significant and we believe it should continue.
- History tells us the recovery of Chinese stocks after a significant selloff can take as long as 24 months, so in our view it doesn’t pay to sell after the initial run-up
- Even after the bounce, Chinese equity valuations are still sitting at notable discounts
- The post-COVID recovery trade may still be at an early stage as Chinese consumers are only beginning to draw down the massive savings accumulated during the pandemic
- China’s monetary and fiscal policies are accommodative which should support equity prices
“We expect emerging markets to outperform U.S. markets if U.S. inflation and interest rates remain higher for longer.”David Dali, Head of Portfolio Strategy
- Dispersion of returns beyond China
Investors have been focused on China's reopening story but many other markets may also benefit.
- Neighboring economies of South Korea, Taiwan and Japan can be supported by rebounding Chinese consumption
- Energy-, mining-, and food-export-driven economies such as Brazil, Indonesia, Peru and Chile can be valuable ballast in portfolio construction
- Mexico’s stock market has been the star so far this year, boosted by the strength of the peso against the U.S. dollar
Unlike many developed markets, most emerging markets (EM) equity valuations already assume significant risks related to prior years’ headwinds, such as China’s pandemic lockdown policy.
- As major advanced economies slip into economic weakness, halving their GDP growth rates to an aggregate of less than 1% in 2023, EM economies are set to maintain their strength just shy of 4%.
- This dynamic typically favors EM equity returns. We expect valuations— trading close to a 10% discount to five-year average—to melt-up as specific risks fade and earnings growth turns decisively positive later this year
- Risks are primarily external
We believe the risks to emerging markets today sit mainly outside of them.
- The U.S. dollar could be stronger for longer but many emerging markets have already proved themselves remarkably resilient to a robust greenback
- U.S.-China tensions are still an overhang but they are for most global equities markets and risk assets
- If developed market policy overshoots it could cause a mild or somewhat severe recession in the U.S. and Europe impacting demand for EM products. We expect EM equities could be more insulated than developed market counterparts during what would be a policy-induced downturn.
Head of Portfolio Strategy
1 Data as of Feb. 24, 2023.
Disclosures and Notes
Investments involve risk. Investing in international, emerging and frontier markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Additionally, investing in emerging and frontier securities involves greater risks than investing in securities of developed markets, as issuers in these countries generally disclose less financial and other information publicly or restrict access to certain information from review by non-domestic authorities. Emerging and frontier markets tend to have less stringent and less uniform accounting, auditing and financial reporting standards, limited regulatory or governmental oversight, and limited investor protection or rights to take action against issuers, resulting in potential material risks to investors. Pandemics and other public health emergencies can result in market volatility and disruption. Investing in Chinese securities involve risk. Heightened risk related to the regulatory environment and the potential actions by the Chinese government could negatively impact performance.
The views and information discussed in this report are as of the date of publication, are subject to change and may not reflect current views. The views expressed represent an assessment of market conditions at a specific point in time, are opinions only and should not be relied upon as investment advice regarding a particular investment or markets in general. Such information does not constitute a recommendation to buy or sell specific securities or investment vehicles. Investment involves risk. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation. Investing in small- and mid-size companies is more risky and volatile than investing in large companies as they may be more volatile and less liquid than larger companies. Past performance is no guarantee of future results. The information contained herein has been derived from sources believed to be reliable and accurate at the time of compilation, but no representation or warranty (express or implied) is made as to the accuracy or completeness of any of this information. Matthews Asia and its affiliates do not accept any liability for losses either direct or consequential caused by the use of this information.
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