At the close of 31 January, MSCI EM was up 10% versus DM up 7% (although DM ex-US Tech was up 14%), while illiquid FM was up 4%.
The Tech sector in EM led the rally – large-cap Tech in China, Korea and Taiwan was up c20% and the Tech stocks sprinkled across small EM (Mercado Libre et al.) were up 25%.
The US dollar (trade-weighted) was down 2.5%, the euro was up 2.0% and a number of hard commodities were up (Copper up 10%, Iron Ore up 7% and Oil up 4%).
Underpinning these moves were hopes on four fronts:
China policy pragmatism – easing zero-Covid and Tech regulatory clampdown, as well as supporting the property sector – may drive a recovery in consumer spending and construction activity;
US interest rate peak may be approaching – eg the University of Michigan Surveys of Consumers reported the one-year inflation outlook declined to 4.0%, from 4.4% in December, the lowest reading since April 2021. The yield on the 10-year Treasury dropped 27bps.
Russia-Ukraine War may not escalate further – although this may be temporary, driven by freezing weather, because of major new arms supplies from Ukraine's allies and no let up in Russian ambition.
Food-related commodity prices were mixed in a narrow range – eg Maize up 6% but Wheat down 3%, Sugar and Soybean flat, and declines of 5% for Palm Oil and 10% for Pork. The broader measure of the UN FAO World Food Price Index registered its first year-on-year decline since mid-2020 – a relief to relatively poor countries reliant on imported food.
Official FX rate devaluations of c15% were seen in countries in external account distress – Egypt, Ghana and Pakistan, none of which are significant weights in either the EM or FM equity index.
Our monthly review of EM and FM equities is laid out as follows:
The month's performance in Emerging and Frontier in one chart.
Low-cost manufacturing valuation chart.
Commodities valuation chart.
Tourism valuation chart.
Technology valuation chart.
Global performance, valuation and liquidity data: Equities, commodities and currencies.
An EM equity strategy for stuttering growth.
Active over Passive: Our EM Country index scores.
Links to recent reports on strategy and economics in EM.
1) The month in one chart
2) Manufacturing
3) Commodities
4) Tourism
5) Technology
6) Performance and valuation data
7) An EM equity strategy for stuttering growth
The combination of Covid, higher US yields, the Russia-Ukraine War and stronger commodity prices have put paid to the era when a successful emerging market equity strategy might have been reduced to a positive call (portfolio overweight) on at least one of the following: Technology (sector), China (country), Asia (region) or largest country weights (liquidity).
Country performance in large and small emerging markets was widely divergent in 2022 and this is likely to repeat this year.
Stuttering and uneven growth suggest that no single theme – eg external account resilience, manufacturing, commodities, tourism, technology, reform – is likely to consistently outperform. The countries we prefer provide exposure to these different themes.
We segment our calls between Large EM and Small EM and FM, given that these are close to (at least) two different asset classes, given vastly different market size and liquidity profiles.
The top seven countries account for over 80% of the MSCI EM index and average daily traded value is over US$60bn, over half of which is in China, compared with cUS$10.5bn, almost half of which is in Turkey, in the remaining 50 emerging and frontier markets.
None of the large emerging equity markets are vulnerable to the sort of external account and currency risks that might have derailed the investment case in the largest EM countries a generation ago and that do impair a number of markets that sit in the long tail of smaller emerging and frontier equity markets (where sovereign dollar bonds probably represent a more palatable option than local currency equities).
While the large EM equity markets are not immune from the negative trade, investment and portfolio contagion impact from rate hikes and weaker growth in the US and EU – the world may be de-globalising and on a path, in some respects, to a tripolar one, but that is not to say that emerging markets are de-coupling from developed ones – they are, in general, more attractively valued.
The very long tail of over 50 small emerging and frontier equity markets offers many ways to gain exposure to our favourite global themes – resilient sovereigns, manufacturing, commodities, tourism, technology and reform – at valuations that are generally more attractive than in large emerging or developed markets.
These are generally markets with extreme diversity; ie they require a lot of research resources to investigate and a myriad of trading and custodial relationships to transact in.
They also exhibit low levels of trading liquidity and, in cases that are exceptional rather than the norm, friction in repatriation of capital; ie this is an asset class for patient capital and for funds with much smaller assets under management than mainstream funds focused on large emerging markets.
Yet, it is these same characteristics that create the opportunity for outsized alpha generation for actively managed funds.
Our top picks are as follows:
Large EM are, in descending order, China, Taiwan, Korea and India;
Small EM and FM are, in descending order, Vietnam, Dubai, Hungary, Chile and Mauritius.
Our least favourite markets, some of which are untouchable for foreign institutional investors who wish to offer daily liquidity to those in their funds, are as follows:
Large EM less preferred: South Africa;
Small EM and FM less preferred: Egypt and Pakistan;
Small EM and FM untouchable: Argentina, Lebanon, Nigeria, Sri Lanka, Turkey and Zimbabwe.
Multiple investment themes (one will not consistently lead)
Parts of EM offer exposure to one or more of five investment themes.
Manufacturing growth: 'China +1' – Alternative manufacturing locations to China that should benefit from US-China friction – Bangladesh, Malaysia, Mexico and Vietnam – are reasonably valued compared with history (although Bangladesh's floor price limits in the equity market are distorting true price discovery).
Tourism revival: post-Covid – Tourist destinations such as Thailand in large EM and others at attractive valuation versus history in small EM – such as Croatia, Georgia, Iceland, Mauritius and the Philippines – offer exposure to the release of pent-up demand after Covid disruption. Other tourist markets that are recovering, but where equity valuations have already positively re-rated, include Dubai and Greece.
Commodity net exports: OPEC+ discipline in oil, renewables transition for copper – Commodity exporters, particularly those not at significant valuation premia versus history, offer exposure to the recovery in global growth. These are found mainly in LatAm: Brazil in large EM in iron ore and agriculture exports, Colombia in oil, and Chile and Peru in copper. All of these have de-rated on concerns over a leftward shift in government, even though many of their current problems were not addressed under the current or preceding right-leaning governments.
South Africa is also cheap relative to its history, arguably reflecting what are now well-understood risks around the ruling ANC party's division, vested interests blocking structural reform, and chronic social inequality and youth unemployment.
Russia and Saudi Arabia clearly have an oil price tailwind in their favour, but Russia's investment case, for foreign investors, has been pulverised by its over-reach in Ukraine and the central bank sanctions this has led to, while Saudi Arabia is, on trailing PB at least, fully valued relative to history.
On the flip side of the commodity trade are the fuel and food importers with low income per capita (ie high portion of household spend on these items), whose growth, inflation and currency are all at greater risk; Bangladesh, Jordan, Lebanon, Pakistan and the Philippines are the most vulnerable in this regard.
Macroeconomic resilience: in the face of high US dollar and US yields – Slower global growth and higher developed market policy rates hurt emerging markets exports (commodity and manufactured goods), remittance, tourism and capital flows.
Compounding these headwinds for EM is strength in the US dollar, particularly, for importers, its coincident rise with US$-denominated commodities like crude oil.
Relative protective cover for EM portfolios for bouts of consensus fears of higher US yields or US dollar strength should be found in countries where:
Real effective exchange rates suggest undervaluation in the current spot FX rate; and
Real interest rates imply central banks are up to speed with inflation and may offer an attractive 'carry trade' for foreigners.
The following EMs have downside in the spot FX rate should their REER revert to the 10-year median of no worse than 5% and a real interest rate that is positive or moderately negative (within negative 2%):
Large EM: Brazil, China and India;
Mid-sized EM: Colombia, Indonesia, Peru and the UAE;
Small EM-Frontier: Bahrain, Iraq, Jamaica, Oman, Tanzania, Tunisia and Ukraine.
Technology: scaled survivors able to drive and benefit from adoption growth – The technology sector, in general, with valuation dependent on long-duration cash flow, growth partly dependent on capital raises and acquisitions, has borne the brunt of the increase in risk-free rates.
This has been compounded by more punitive global and domestic regulation and the drop off in demand caused by the end of Covid lockdowns and the overall economic slowdown.
The resulting shakeout of the sector likely eliminates the immature and underfunded and reinforces the competitive position of those that have scale and deep pockets.
Nevertheless, on the structural demand side, tech adoption cycles (5G, artificial intelligence and machine learning, quantum computing, virtual and enhanced reality, datafication, blockchain, 3D printing, etc.) should continue, just without the super-charge of sustained home working, education and entertainment.
China's mega-technology companies, Alibaba and Tencent, are among the cheapest and most liquid exposure to structural growth, which has benefited, of course, from Covid-19 disruption but will outlast it, albeit the entire sector now has to conform to the diktats of the one-party state (which is what their de-rated valuations already reflect).
The largest and arguably most durable tech companies in the EM equity universe, eg China applications companies Alibaba and Tencent or Korea and Taiwan hardware companies like Samsung and TSMC, are on valuations well below their historical averages.
The valuations of Taiwan and TSMC, in particular, arguably much more fully reflect the risk of conflict with China compared with the start of 2022.
In small EM, where scarce liquidly-traded tech exposure once drove premium valuations relative to global peers, the lack of a dedicated institutional investor base now drives discounts even for the likely scaled survivors, eg Mercado Libre in LatAm.
Some of these themes appear contradictory but that is intentional in an environment of stuttering, uneven growth, when one type of exposure will not consistently lead global equity markets.
Structural reform is missing but so is distress in large index countries
Structural reform (self-help) is a slow and stop-start process but a powerful driver of the long-term investment case in emerging markets. It is sorely lacking at the moment, having not, in general, revived following the buffeting from the crises of Covid, high commodity prices and US dollar strength – Dubai and, to a degree, Indonesia, are exceptions.
However, the largest EM equity markets are not of the type traditionally associated with sovereign vulnerability at a time of global stress. China, India, Korea and Taiwan in EM are not immune from currency depreciation in such a strong US dollar environment but they do not have vulnerable external accounts in the manner of Mexico and others in LatAm, or Russia, a generation earlier. The same could be said of Vietnam, Morocco, Iceland and Kazakhstan – the largest components of FM.
Instances of macroeconomic external account vulnerability, capital controls or currency convertibility are restricted to countries that are negligible equity index weights – eg Argentina, Ghana, Lebanon, Nigeria, Pakistan, Sri Lanka, Turkey and Zimbabwe.
And instances of equity market distortions and inefficiencies are rare; eg floor price regulation in Bangladesh or the dominance of related-party, listed companies in Abu Dhabi.
Off-radar markets the exceptions, not the rule
Bad policy
A poor, foreign equity investor-unfriendly policy environment rules out the following markets: Argentina, Lebanon, Nigeria, Turkey, Sri Lanka, Tunisia and Zimbabwe.
There is sufficient opportunity at appealing valuations elsewhere in EM to avoid these. And the most appropriate way to access these markets for foreign investors is, for the time being, via their traded eurobonds.
Elections this year offer a potential catalyst for positive policy changes in some of these markets but we are not hopeful.
Perhaps, Nigeria, alone in this list, offers the possibility of change should opinion poll leader, Peter Obi, win the February 2023 presidential election and implement even a subset of the economic reforms he has promised, albeit he will have to work with a parliament he is unlikely to control.
Sanctions
Sanctions and capital controls, driven by geopolitics as opposed to populism or unorthodox monetary policy, take Iran and Russia completely off the radar.
Abu Dhabi special case
Abu Dhabi, which is increasingly dominated by related-party companies – eg International Holding Company, Alpha Dhabi and Aldar – has become something of a special situation, with the interplay between these companies already more important than, for example, oil prices or regional geopolitics, for trading volume and country index performance.
This does not make Abu Dhabi an off-radar market, particularly in an era of high oil prices and a strong US dollar, but the top-down framework we apply to EM equities may not be that instructive.
8) Active over passive: Our EM Country Index
This combination of global positives and risks drives an outlook of uneven, stuttering growth across EM and implies there will not be consistent market leadership by one region, country, sector or theme.
Therefore, our top-down strategy is grounded in active country selection over passive index-tracking and exposure to a mix of manufacturing, tourism, commodities, macroeconomic resilience and technology, where this exposure is cheap relative to history.
The main guide for picking countries, for us, is a combination of equity market valuation and liquidity, short- and long-term macroeconomic growth prospects, economic policy credibility and currency risk.
These are all key components of the customisable Tellimer EM Country Index, which also incorporates sanctions exposure, as well as longer-term ESG and climate risk factors.
Our top picks, resulting from our multifactor screen of the EM country equity universe, are both particularly cheap and offer exposure to these themes.
Our index weights c30 factors on growth (short and long term), policy credibility, politics, sanctions, ESG, equity valuation and liquidity.
Around 85% of the index's weight covers factors relevant for all asset classes, with the remaining 15% specific to equities. For foreign direct investors wishing to assess a wide range of country risk factors, this model can be adjusted by simply applying zero weight to the equity market factors.
Because trading liquidity is a part of the equity component, and China is much more deeply traded than all other EM, this has a major bearing on China's score.
We try to strike a balance between the short and long term, with a value bias. That is not everyone’s approach, and the EM Country Index can be flexed to reflect different approaches (eg more risk-averse, less valuation-centric).
Contact Tellimer Insights Sales to learn more about accessing the customisable version of our index.
9) Recently published reports
Global
Large EM equity strategy: 2023 outlook
Small EM and FM equity strategy: 2023 outlook
Elections in Argentina, Nigeria, Pakistan, Poland, Thailand, Turkey in 2023
Food prices drop year-on-year for first time since mid-2020
Local currency yield premium moderates to pre-pandemic levels (Curran)
Asia
Asia EM equity strategy: 2023 outlook
India: A bad week for nationalists and a challenge for ethical or ESG investors
Vietnam: Anti-corruption ensnares president, highlighting succession risk
Pakistan: Currency devalued as warning signals flash bright red (Curran)
Pakistan: SBP pumps the brakes as country nears default cliff (with Curran)
Middle East
Middle East EM equity strategy: 2023 outlook
LatAm
LatAm EM equity strategy: 2023 outlook
Brazil riots not a prompt for a coup but a reminder of Lula’s challenges
Brazil-Argentina common currency: An idea so bad, why is it being discussed?
Mexico's drug cartel war might overwhelm the manufacturing near-shoring thesis
Colombia's central bank delivers a lower-than-expected rate hike (Culverhouse)
Peru hikes again as political crisis continues (Culverhouse)
Europe
Europe-CIS EM equity strategy: 2023 outlook
Africa
Africa EM equity strategy: 2023 outlook
Egypt: Currency devalued again to absorb external shocks (Curran)
Ghana's Common Framework request (Culverhouse)