So far in June, the MSCI EM index is down 5% and MSCI World (developed markets) is down 9%. Even commodity exporters, which have outperformed substantially year to date, have been hit hard: Indonesia, Brazil, Chile, Colombia, Indonesia, Saudi are down in the range of 7% to 14%.
We take a breath and recap our emerging market equity strategy views. This boils down to two parts.
Cheap, relative to historic average valuation multiples, mix of:
Commodities (Brazil, Colombia, Indonesia, Oman, Qatar)
Tourism (Georgia, Greece, Mauritius, Thailand)
Manufacturing (Mexico, Vietnam).
For now, dodging those most exposed to fuel and food inflation (eg Bangladesh, Egypt, Pakistan, Philippines).
No consideration is given for those markets under the woke of self-destructive economic policies (Argentina, Lebanon, Nigeria, Sri Lanka, Turkey, Zimbabwe) or US sanctions (Russia).
A rout in June so far
Emerging markets equity strategy recap: Cheap tech, commodities, tourism, manufacturing and reform
The 2022 global backdrop is featuring the following.
Dissipating global Covid disruption (higher levels of vaccination and prior infection, prior deaths of the most vulnerable, less fatal variants and intolerance of further lockdowns) but lingering lockdowns in China, which remains wedded to a zero-Covid strategy.
Strengthening US dollar (as the US Fed embarks on a rate hiking cycle and US yields move up, a prolonged Russia-Ukraine war raises European stagflation risk and drags down the Euro).
Except for China, much less room for policy stimulus in emerging markets (as Covid-era fiscal deficits are narrowed and interest rates are hiked to cope with higher inflation).
Pressure on local investor flows in those EMs where local interest rates and bond yields are moving up.
All of this adds up to a continuation of uneven, stuttering growth across EM, and a greater emphasis on country, sector and stock selection.
A mix of cheap tech, commodities, tourism, manufacturing and reform
China technology (particularly Alibaba and Tencent) is 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).
State interference and tougher regulation in publicly listed tech is only now becoming more prominent, and may not yet have run its course in other markets, eg Russia tech.
While tech adoption cycles (with 5G and the metaverse next round the block) still favour pricing for most of Korea-Taiwan tech hardware (also helped by the semiconductor shortage) and Indian IT services, valuation already reflects this. For Taiwan and TSMC in particular, there is arguably no reflection of China conflict risk.
In small EM, where scarce tech exposure has driven premium valuations, among the most liquid plays, Mercado Libre is looking cheaper relative to its history than Sea.
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 ruling ANC party division, vested interests blocking structural reform, and chronic social inequality and youth unemployment.
Russia and Saudi 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 is expensive 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.
Tourist destinations like Thailand in large EM, and others at attractive valuation versus history in small EM – such as Croatia, Egypt, Georgia, Greece, 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 Iceland.
Alternative manufacturing locations to China that should benefit from US-China friction – Bangladesh, Malaysia, Mexico and Vietnam – are reasonably valued compared with history.
Structural reform (self-help) is a slow and stop-start process, but despite the Covid shock and domestic political challenges, this continues in Indonesia, which is cheap relative to history, although we have become less optimistic on reform prospects in two other cheap markets, Pakistan (with the Khan-led PTI government out of power) and the Philippines (with dynastic politics taking centre stage).
India less appealing in 2022, Kenya risks now priced in
India offers exposure to many of these traits (particularly leap-frogging technology, alternative manufacturing location to China and pro-business reform), but it is no longer as cheap relative to history, particularly should monetary policy tighten at any point this year, or as committed to reform as a year ago (with Prime Minister Modi's priority now on impending state elections this year, particularly in Uttar Pradesh).
Kenya, in small EM, similarly offers exposure to some of these traits (particularly leap-frogging technology and tourism revival), but the focus on the election this year continues to distract from structural reform and external liquidity is likely to come under pressure. But valuation of both the largest stock, Safaricom, and the banks may be at sufficiently discounted valuation relative to historic average to reflect these risks.
Off-limits markets: For example, Argentina, Nigeria, Turkey, Sri Lanka, Russia
A poor, foreign-investor-unfriendly policy environment rules out the following markets: Argentina, Lebanon, Nigeria, Turkey, Sri Lanka and Zimbabwe. There is sufficient opportunity at appealing valuations elsewhere in EM to avoid these.
Sanctions and capital controls, driven by geopolitics as opposed to populism or unorthodox monetary policy, take Russia off limits.
Non-country strategy market: Abu Dhabi
Abu Dhabi, which is increasingly dominated by related party companies – International Holding Company, Alpha Dhabi, and Aldar – has also become something of a special situation, with the interplay between these companies already more important than, for example, oil price or regional geopolitics, for trading volume and country index performance.