Emerging-Frontier Equity Monthly – January: Tech, Russia hit as Oil, Brazil soar

Tech hit, oil soars, Russia war fears, China eases, Brazil and Chile move to centre, Kazakhstan purge

In January, concerns over Omicron Covid receded, but fears over US inflation and the Fed's hawkish pivot, as well as geopolitical friction around Russia, pushed the US 10-year bond yield up 26bp to 1.77%, the US dollar (trade-weighted) up 1 percentage point (euro down almost 2pp), significantly de-rating technology valuations (which are sensitive to the discount rate applied to free cash flow well into the future), and boosting commodity prices (particularly oil, up 16%).

At the market close on 29 January, MSCI EM and FM were down 3% and 4%, respectively, compared to DM and DM ex-US tech down 18% and 7%, respectively.

In Large EM, the highlights were as follows:

• Brazil (up 11%, across all sectors, with FX rate up almost 3%) outperformed after Luiz Inácio Lula da Silva, the leader in polls for the presidential election in October, again courted the centrist electorate with a suggestion that his running mate could be Geraldo Alckmin, and amid a 17% increase in iron ore prices (on hopes for stimulus in China, with 10% of exports from iron ore and with Vale over 15% of the equity index).

• Saudi (up 8%) was helped by oil price strength (and an 18% increase in ethylene prices which benefit the petchem sector) as well as expectations of fiscal stimulus (which should keep construction and consumption buoyant) and rising US rates (which help the Saudi banking sector).

• Russia (down 10%, with FX rate down 4%) underperformed – despite oil price strength – on concerns around the escalation of tensions in Ukraine (ie risk of wider sanctions). Arguably, President Putin has reached a point of maximum leverage — built on EU gas supply dominance (which splits attitudes to Russia within NATO and the EU) and a greater willingness to commit troops relative to the US — to prevent Ukraine (even its western part) from joining NATO and to secure regulatory approval for the NordStream2 gas pipeline. A full-blown invasion would risk reducing this leverage because it would be financially costly (triggering wider sanctions and eating into recently accumulated fiscal surpluses), militarily risky (Ukraine is better armed than in 2014), unpopular domestically (when soldiers perish), permanently damaging for relations with Germany (NS2), and ultimately push the western part of Ukraine closer to NATO. But the pendulum of consensus opinion has clearly swung away from this argument in the last month.

• South Korea (down 12%) also underperformed on geopolitical concerns, ie the resumption of missile tests by North Korea, and cost pressure and supply chain disruption which hurt profit margins in the quarterly results of bellwether Samsung Electronics (down about 10%).

• Elsewhere, Taiwan (down 2%) continues to see friction with China and foreign investor outflows but ever higher index weight for TSMC (up 3%), China (down 5%) showed signs of slowing but initiating policy stimulus, and India (down 4%) opinion polls appear to show the ruling BJP is still in pole position in Uttar Pradesh state elections in February-March.

In Small EM and FM, the highlights were as follows:

• Chile (up 12%, with FX rate up almost 6%) was the biggest outperformer, after President-elect Gabriel Boric appointed the current central bank governor, Mario Marcel – who has a track record for supporting orthodox economic policy – as finance minister.

• Colombia (up 9%, with FX rate up almost 3%) was driven by acquisition bids for different assets in Grupo Empresarial Antioqueno (Nutresa, Sura, Bancolombia, Argos) from Jaimie Gilinksi and, to a much lesser degree, oil price strength and a 100bp rate hike (cumulative 500bp since the start of 2021, which leaves the real interest rate at negative 1.7%, the lowest in Latam ex-Brazil). Meanwhile, opinion poll support for the Historic Pact party of leftist Gustavo Petro has increased (from 26.5% in December to 31.1% in January in the Guarumo poll) and he has made publicly critical comments of (orthodox) interest rate policy and oil exploration. The parliamentary election is on 13 March and the presidential election (incumbent Duque is limited to one term) is on 29 May.

• Qatar (up 8%, with strength across all the larger stocks) caught up some of its lagging performance over the past year versus GCC hydrocarbon-exporting peers but without a specific new catalyst (although there is potential for Qatar LNG exports to fill a portion of any supply cut from Russia, the long-term nature of LNG supply contracts implies little direct implications from Russia-Ukraine tensions in the short-term, the economic boost from the World Cup in Nov-Dec 2022 has been long anticipated, and the legal changes for higher foreign ownership limits were made last year).

• Mexico (down 8%, with FX rate down 1.6%) was driven by a mix of concerns over global supply chain disruption, US growth and US dollar strength, as well signs of divisions within President Andrés Manuel López Obrador's MORENA party (40% and 48% of the lower and upper houses of congress, respectively) and its coalition partners Ecological Green and Labour (collectively, 15% and 8%, of the lower and upper houses of congress). These coalition parties are fielding separate candidates in some of the 5 June governor elections. MORENA lost its absolute legislative majority in the June 2021 elections.

• Kazakhstan (down 25%) was driven down by violent protests which resulted in the effective side-lining of former President Nazarbayev, and the purge of his long-standing patronage network, followed by the invitation by current President Tokayev to the Russian-led CSTO (Collective Treaty Security Organisation) to re-establish security.

• Tech in Small EM-FM (down 34%) was hit by the Fed's hawkish pivot (higher US rates implies higher discount rates applied to the free cash flow far into the future, which underpins the valuation of most loss-making tech stocks in small EM-FM). Sea (down 39%) was also hit by Tencent's sell-down of its stake (from 21.3% to 18.7%) and existing concerns about its dependence on gaming revenues (which are slowing) and cash burn in new businesses. Sea's share price is back to levels last seen in mid-2020 (still up over 10x since the 2018 IPO, with a peak increase of 35x reached in May 2021).

• Elsewhere, the UAE was attacked by Yemen's Houthis and may be permitting gambling, Pakistan (up 1%) finally appears to be getting its IMF loan back on track, and global food inflation may have peaked.

Our monthly review of EM and FM equities is laid out as follows:

1. The month's performance in Emerging and Frontier in one chart

2. Technology valuation chart: Major de-rating amid US Fed turn

3. Commodities valuation chart: Oil price rallying more than copper

4. Tourism valuation chart: Omicron threat recedes

5. Global performance, valuation, liquidity summary table: Equities, commodities, currencies

6. EM equity strategy recap in 800 words

7. Links to recent reports on strategy and economics in EM

1) The month in one chart

2) Technology: Major de-rating amid US Fed turn

3) Commodities: Oil price rallying more than copper

4) Tourism: Omicron threat recedes

5) Performance and valuation summary

6) EM Equity strategy recap: cheap tech, commodities, tourism, manufacturing and reform

The 2022 global backdrop looks like it's going to feature, with some hiccups along the way, the following:

• Stable to higher Oil and commodity prices (as global growth remains positive and the legacy of under-investment in commodity extraction persists).

• Dissipating Covid disruption (higher levels of vaccination and prior infection, prior deaths of the most vulnerable, less fatal variants, and intolerance of further lockdowns).

• Flat to down US dollar (as global growth normalises but US rates and yields slowly move up).

• 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 slowly 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

1. 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.

2. 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 is marred by geopolitical risk (conflict in Ukraine and additional US sanctions) and Saudi is expensive relative to history.

3. 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 which are recovering, but where equity valuations have already positively re-rated, include Dubai and Iceland.

4. Alternative manufacturing locations to China that should benefit from US-China friction – Bangladesh, Malaysia, Mexico and Vietnam – are reasonably valued compared to history.

5. Structural reform (self-help) is a slow and stop-start process, but despite the Covid shock and domestic political challenges, this continues in at least two markets that are cheap relative to history, Indonesia and, more so, Pakistan.

India and Kenya less appealing in 2022

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 PM 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 its largest stock, Safaricom, is at a premium to historic valuation, its banks are no longer at distressed valuation, the focus on the election this year continues to distract from structural reform, and external liquidity is likely to come under pressure.

Off-limits bad policy markets: eg Argentina, Turkey, Sri Lanka

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.

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.

7) Recently published reports

Global

2022 EM equity strategy: Passive index tracking is not the answer, 5 Jan

IMF's updated growth forecasts across emerging markets, 27 Jan

Oil importer alarm bells ring, 18 Jan

Food prices decelerate again but still near 10-year peak, 7 Jan

EM central banks still ahead of the curve but vulnerable as Fed liftoff nears, 18 Jan (Curran)

ESG

Serbia stops Rio Tinto's Lithium mine, echo of Chile – renewables reality check, 21 Jan

Africa

South Africa's road to 2024 elections: weak macro outlook, 28 Jan (Curran)

Ghana bonds start the year under even more pressure, 21 Jan (Culverhouse)

Ethiopia rallies on positive conflict news, 27 Jan (Curran)

Asia

Taiwan foreign equity outflows amid China friction but index weight still rising, 25 Jan

India opinion poll bodes well for ruling BJP in Uttar Pradesh and nationally, 24 Jan

China slowing, not stopping: Policy stimulus and equity inflows in 10 charts, 17 Jan

Pakistan: Underperformance unjustified, but risks remain high, 25 Jan (with Curran)

Sri Lanka: Busy week fails to improve repayment prospects, 20 Jan (Curran)

North Korea: What to make of its recent missile tests, 19 Jan (Culverhouse)

Europe

Russia and its security buffer, 10 Jan

Kazakhstan impact on Uranium, Ukraine, Bitcoin, Putin's succession, FM equities, 6 Jan

Turkish lira stability could be short-lived, 20 Jan (Curran)

LatAm

Brazil: Lula courts centrists and cuts risk of radical shift left, 20 Jan

Argentina and IMF reach an understanding, 28 Jan (Culverhouse)

Middle East

UAE and Dubai: Place your bets? Licensed gambling window opens in Ras Al Khaimah, 26 Jan

UAE drone attacks claimed by Yemen Houthis, 17 Jan