After two painful years, the outlook for emerging market equities has notably brightened, according to strategists at SPDR, the ETF business of State Street Global Advisors (SSGA).
Krzysztof Janiga, Equity ETF Strategist at SPDR.
Emerging market equities faced continued pressure from the end of 2020 due to numerous converging factors including China’s regulatory crackdown and zero-COVID policy, the strengthening of the US dollar, and the war in Ukraine, all of which reinforced a risk-off tone amongst investors.
The flagship MSCI Emerging Markets Index sunk some 39.8% between its peak on 15 February 2021 and its recent bottom on 24 October 2022.
The segment has begun to bounce back somewhat, however, with the index gaining 16.1% since its recent low, as of 8 March. According to Krzysztof Janiga, Equity ETF Strategist at SPDR, the gains appear likely to continue as, importantly, the improved economic outlook for emerging markets is being driven by forces that are expected to play out across a medium to long-term horizon.
Source: SPDR.
Pivotal U-Turn in China
China, which represents a third of the MSCI Emerging Markets Index, had been a major source of the segment’s issues in recent years; however, Janiga points out that the factors causing the country’s woes are starting to be resolved.
Janiga commented: “The faster-than-expected reopening removes the key headwind and may allow China to unlock the potential of its economy and contribute to further supply chain easing in the medium term. The end of the zero-COVID policy will have a profound impact on both the Chinese and global economies. While market participants appeared to have initially underappreciated this development, now (unsurprisingly) we have started to see improvements in Chinese GDP forecasts.
“China’s reopening also coincides with a less stringent approach toward tech regulation. This shift is pivotal for the emerging markets equity complex, as some of the largest constituents in the MSCI Emerging Markets Index faced Chinese regulations and, therefore, have been sold off since late 2020. A continuation of the softer stance may benefit not only tech giants but also the broader technology sector as it will encourage (or stop discouraging) new investments.
“In the short run, this new environment could cause volatility – as we observed in February – due to increased competition among Chinese companies; however, in the long term, we believe a lighter touch from Chinese regulators will lead to a more healthy business environment and, as such, is a key element of the emerging markets equity story.”
Robust Real GDP Growth Outlook
Janiga notes, however, that emerging markets growth will not only be driven by China. India, which accounts for 13% of the MSCI Emerging Markets Index is expected to enjoy even stronger growth during the next two years, while other major emerging market economies such as Taiwan (14% of the index), South Korea (12%), and Brazil (5%) are also poised for rapid development.
While emerging markets do tend to grow faster than advanced economies, Janiga believes that current projections look particularly appealing given the broader growth scarcity among developed economies.
Source: SPDR.
Disinflation will Prevail…Eventually
While inflation has had a serious impact across emerging markets in a number of ways, many of the largest countries in the segment, including China, Taiwan, and South Korea, are expected to see their inflation rates continue to slow down over the next two years.
Additionally, economists at SSGA expect US inflation to moderate more rapidly than the market might expect as the ‘seasonal noise’ around both January and December’s inflation readings may be exaggerating the true inflation picture. Slower inflation will help to bring about an end to the Federal Reserve’s tightening cycle which could potentially weaken the US dollar over the medium term, setting up another boon for emerging markets.
Valuations Remain Unstretched
SPDR believes that the valuations for the MSCI Emerging Markets Index remain undemanding relative to the developed world.
“While acknowledging that emerging markets have historically traded at a discount given a higher risk-reward profile, the economic growth advantage makes the current valuation discount particularly attractive relative to developed markets,” said Janiga.
Investors should be wary of risks, however, with several medium-term threats being apparent including a material escalation of the China-US tensions around Taiwan or Russia, the possibility of China reverting to a more stringent approach toward tech regulation, and a potential deterioration in China’s property sector.
The SPDR MSCI Emerging Markets UCITS ETF provides low-cost access to the MSCI Emerging Markets Index. The fund houses $320 million in assets and comes with an expense ratio of 0.18%. It is listed on London Stock Exchange in US dollars (EMRD LN) as well as on Deutsche Börse Xetra (SPYM GY), Euronext Paris (EMRG FP), and Borsa Italiana (EMRG IM) in euros.