At the close of 29 November, MSCI DM ex-US Tech was up 14% month-to-date, whereas DM overall was up 5%. EM was up 10% and illiquid FM was up 3%.
Amid this month's drop in the US dollar (down 2.6%) and oil price (down 10%), there has been a small reversal in performance seen year to date in EM.
This is best exemplified by the bounce in China (up 19%) and Taiwan (up 21%) versus the drops in Brazil and Saudi Arabia (both down 8%).
Around the equities world this month
US dollar (trade-weighted) was down 2.6%, although the real effective exchange rate remains near a multi-decade peak, and the US 10-year yield was down 37bps, to 3.7%, significantly below the 4.2% last decade peak seen in late October. For more detailed discussions of the implications of relatively high US dollar and US yields for EM, please click on these report links: US dollar and US yield.
Oil price (Brent) was down 10%: the early October OPEC+ quota cut is being overtaken by concerns over slowing global growth.
Food-related commodity prices were mixed, with Wheat, Pork, Sugar and Urea down 5-13% but Palm Oil, Maize and Rice up 7-8%. There was relief for wheat importers, eg Egypt, that Russia rejoined the deal to allow safe transit of grain exports from Ukraine, after a brief withdrawal at the end of October.
China (up 19%, with the FX rate up 2%, and the largest Tech stocks up 28%): the outbreak of protests over lingering Covid restrictions, but that, in some cases, also included criticism of the political leadership, at the time of writing, subsided after three days. Over the course of the month, a shift to more 'pragmatic' Covid policy and greater government support for the indebted property sector drove equities higher.
Malaysia (up 8%, with FX rate up 5%) rose after a new alliance of the blocs of Prime Minister Anwar’s Pakatan Harapan (39% of seats) and erstwhile opponents Zahid and Razzak's Barisan Nasional (14%) enabled the formation of a new government, despite the election resulting in a hung parliament. The coalition is fragile, with splits between those in favour of economic (privatisation and greater transparency in public finances) and those who prefer the status quo, and potential for a change to the leadership of the BN, which is less willing to work with Anwar.
Bangladesh (flat) performance was seemingly oblivious to the IMF deal which shores up the FX rate after a 15% drop ytd, with the new credit facilities equating to two-thirds of existing FX reserves. The IMF deal may not guarantee lasting structural reforms, eg fully flexible currency, closure of tax exemptions (tax/GDP is c8%), and full recognition and resolution of legacy non-performing loans and low capital adequacy in state-owned banks (NPLs are c20% of loans in the state-owned banks and c7% in the overall sector, and capital adequacy is c6%, in terms of risk-weighted assets, in state-owned banks, versus the 10% regulatory requirement). Nor does it address the impairment of efficient price discovery in the equity market, with regulatory limits on daily share price falls still in place.
Vietnam (up 1%, with FX rate flat) appeared to suffer from potential China supply chain disruption, eg the riot at Foxconn’s Zhengzhou factory, slowing global demand growth, with monthly exports falling 8.4% yoy, and bureaucratic drag from the ongoing anti-corruption campaign. Vietnam is a long-term beneficiary of the addition of new global manufacturing capacity outside China but, in the short and medium terms, its supply chain is closely interwoven with that of China – imports from China (which are typically processed into more finished export products) equate to around one-third of Vietnam GDP. FDI is down 5% yoy in the year to end-November.
Saudi Arabia (down 8%) fell in line with the decline in the oil price (down 11%) and US dollar (down 3%). Data on the non-oil economy remains bullish – for October, PMI was 57.2 and point-of-sale transactions grew 18% yoy.
Qatar (down 6%) fell despite the completion of two major long-term LNG export deals with China (4mt annually for 27 years) and Germany (2mt annually for 15 years). Qatar is ramping up export annual capacity from 77mt to 126mt by 2027.
Region-wide factors – euro appreciation of 4.6% and no further escalation in the Russia-Ukraine War, demonstrated by the very muted reaction to a missile explosion in Polish territory – were behind the bounce in most of the European emerging markets. This even included Poland (up 19%, following a double-digit increase in the prior month), despite its dispute over the rule of law risking access to EU funding. Hungary (up 19%), which has a similar EU dispute but obtains 17% of its total energy needs from Russian gas imports compared with 7% for Poland, also benefited.
Kazakhstan (up 12%, with FX rate flat) was helped by the rubber-stamp election victory for incumbent President Tokayev, with 81% of the vote amid a turnout of 69%. In the near term, higher public spend on wages, pensions, health care and education is likely. This should be affordable given post-Covid fiscal deficits in the range of 1-2% of GDP. Tokayev will almost certainly continue Kazakhstan's almost unique tradition of balancing China, Russia and the US-EU in foreign policy. Whether he can use his single term until 2029 to emulate the sort of economic reform to state-owned enterprises and sovereign wealth introduced in a short time in another commodity exporter with a concentration of political power, Saudi Arabia, remains to be seen.
Brazil (down 8%, with FX rate down 3.5%) suffered over concerns on fiscal direction under newly elected, leftist President Lula, after speculation that he may appoint close political ally Fernando Haddad, instead of ex-central banker Henrique Mereilles, as finance minister. Regardless of his appointments, Lula will have to manage congress, over which he exerts very little control (his own political bloc has 16% of lower house seats), in order to cut the fiscal deficit (7.5% of GDP in 2023) and pass meaningful reforms. Brazil equities and currency are cheap versus the historical average and cheaper than most large emerging market peers, but their outperformance for much of this year has occurred with the tailwind of high commodity prices.
Peru (up 7%, with FX rate up 3.6%) as US$ dollar weakness and strength in the price of copper (up 8%) offset continuing political dysfunction. President Castillo – a survivor of two impeachment attempts by a congress over which he exerts no control and the subject of a criminal investigation – appointed his fifth prime minister. Congress is powerful enough to block legislation but too fragmented to force two votes of no confidence in a row in either the prime minister or cabinet, for fear of triggering a suspension and an early election.
Mexico (up 5%, with FX rate up 3%) was immune from large-scale, opposing political rallies, both against and in favour of President Lopez Obrador’s proposals to reform the electoral commission, which may increase his influence over it. Lines are being drawn in the run-up to the next election in 2024 – the incumbent is restricted to a single term. Political risk aside, Mexico should benefit from a pick up in investment related to 'near-shoring' of manufacturing and a revival of tourism.
Egypt (up 15%, with FX rate down 2%) rallied following the end-of-October IMF deal. Monetary and fiscal policy tightening and a more flexible currency regime are likely the short-term term conditions of the deal. It remains to be seen how demanding the conditions are for longer-term structural reform, which levels the competitive playing field between state or military-owned enterprises and the private sector.
Nigeria (up 6%, with flat official FX rate), got a bump from another surprise policy rate hike to 16.5%, the fourth consecutive hike since May took the cumulative move to 500bps. While a more orthodox approach is welcome, the real interest rate is still negative 4.6% and the FX market remains dysfunctional. At the start of November, the parallel FX rate implied a 50% devaluation, although this subsequently moderated to 40%. The likelihood of FX liberalisation in the near term is low given the next election is due in February 2023. It remains to be seen whether opinion poll leader, Peter Obi, prevails and implements the mouth-watering economic reforms (central bank independence, unified FX rate, cuts to import restrictions, fuel subsidies and fiscal deficit) he has promised.
Ghana (down 4%, with FX rate down 4%) continues to grapple with sovereign debt restructuring, confirmed, without detail, in its budget presentation this month. At this stage, it appears that at least a 30% haircut on foreign bonds is on the way.
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: Cheaper in China, Hungary, Korea, the Philippines and Vietnam.
Commodities valuation chart: Cheaper in Chile and Peru in Copper, and Colombia, Kuwait, Oman, Qatar and Saudi Arabia in Oil
Tourism valuation chart: Cheaper in Croatia, Georgia, Iceland, Jamaica, Mauritius, the Philippines and Thailand.
Technology valuation chart: Cheap, scaled Tech in EM in China, Taiwan and Mercado Libre.
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: China Covid disrupts related supply chain but long-term shift to Mexico, Vietnam et al
3) Commodities: Demand destruction fear
4) Tourism: Post-Covid recovery underway
5) Technology: Higher risk-free yields a headwind for valuation of long-duration cashflows
6) Performance and valuation data
7) An EM equity strategy for stuttering growth
Stuttering and uneven global growth
A range of factors, while remaining unhelpful in the near term and contributing to a stuttering and uneven growth environment, are losing their capacity to shock:
Higher US inflation, US rates and US dollar – However, the peak in US policy rates may be on the horizon, which may portend a peak in US dollar strength too, particularly with the US real effective exchange rate near a two-decade high.
Russia-Ukraine War and its knock-on impact on global food prices, and a rushed energy transition negative growth shock in the EU,
China-Taiwan tension and broader China-US friction, and
China's self-inflicted policy wounds on zero-Covid strategy, distressed property debt and technology regulation.
The peak in US policy rates may be on the horizon, which may portend a peak in US dollar strength too, particularly with the US real effective exchange rate near a two-decade high.
While IMF global growth forecasts for 2023 were cut in October 2022, the premium of EM over developed market growth has widened, from 2.1 to 2.6 percentage points.
Covid is dissipating globally and that is positive for EM manufacturers (eg Vietnam, Bangladesh and Mexico, etc., in terms of both global demand recovery and smoother supply of intermediary inputs from supply chains directly linked to China) and EM tourism economies (eg Thailand, the Philippines, Dubai, Iceland and Mauritius, with international tourist arrivals growing sharply but still, in Thailand for example, less than half its pre-Covid level).
Food prices are back to levels seen prior to the Russia-Ukraine War, ie still elevated, c45% above the pre-Covid 2019 full-year average but no longer accelerating at the severe pace seen between Q2 2020 to Q1 2022.
US-China competition and friction persists but, at least, direct dialogue has resumed and red lines of engagement have been defined around Taiwan, for China, and cutting-edge semiconductor technology, for the US.
The largest EM by far, mainland China with a 27% weight in MSCI EM, has the rare capacity for stimulus – with a positive real interest rate, currently 0.7%, albeit fiscal deficits are in the range of 8% of GDP – and with the distraction and drama of the Communist Party Congress behind it. While not definitive, China's policies on Covid, property and regulation appear to have taken a more pragmatic turn following the Congress.
The largest countries in EM equities – China, Taiwan, Korea, India, and to a degree, even Brazil – do not have external account vulnerability, in terms of a combination of large current account deficits, low import cover and high short-term external debt. And there are pockets of EM – Saudi Arabia and the GCC – that have the crude oil exports and FX reserves to provide perhaps as much downside protection as any developed market, after the US.
The EM countries with chronic external account stress are either trivial weights in the MSCI EM and FM indices, or no longer part of them and, even among this group, several have submitted to the corrective policy conditions of the IMF (Argentina, Ghana and Sri Lanka), with, in some cases (Egypt, Pakistan and Tunisia), help from geopolitical allies to boot. Lebanon is an exceptional case where an IMF framework is in place but there appears no political mandate to correct course on policy.
An off-ramp for the Russia-Ukraine War may be taking shape, following territorial setbacks for Russia, ongoing external funding and armament for Ukraine, economic sanctions on Russia taking full effect, potential challenges for President Putin from domestic dissenters, diplomatic softening of China's support for Russia (eg concerns voiced over the nuclear weapons threat), the Biden-Xi meeting in November where de-escalation in Ukraine appeared one of the few areas of common ground, and the quick response by the US to quieten any talk of NATO intervention after an explosion was reported in Poland in November.
Most of the largest global asset allocators compare the prospects of EM equities to US equities. The case in favour of the US – built on a period of very loose monetary and fiscal policy, the transition towards energy self-sufficiency and a technology-driven productivity boost – may be running its course as the financial excesses of the last decade unravel (eg contagion from the crypto collapse) and extreme political polarisation and inequality fuel populist policy and inhibit addressing structural issues (eg legislative gridlock, aged infrastructure and access to health care).
Russia-Ukraine can escalate economically (more gas supply suspensions from Russia), militarily (eg a spread to separatist parts of Georgia and Moldova, provocation on the Finland border or in the Baltics) and geopolitically (a more forceful 'Western' response to the 'neutral' stance of China, India and others).
China’s regulatory crackdown and zero-Covid policies have not ended and its property debt crisis has not been resolved, and the continued emphasis on public infrastructure spend may risk more capital misallocation. In particular, the resolve to move away from Covid lockdowns will be tested by the inevitable spike in infections and critical cases, given the lack of MRNA vaccine deployment.
Political protest movements against a backdrop of elevated food prices or acute inequality pose a threat to the smooth working and, in some cases, survival of any incumbent government, whether autocratic or democratic, poor (Africa, South Asia) or relatively affluent (LatAm, East Europe).
Brazil, India and South Africa are not structurally reforming, with populism or re-election driving policy in all three. Reform efforts, involving unpopular retraction of subsidies or reduction of unproductive public sector employment in the likes of Egypt, Pakistan, the Philippines and Vietnam have petered out under the economic stress from Covid as well as food and fuel inflation.
Already reflected in the valuation of EM
These factors already may be reflected in valuation with most of the EM equity, and associated currency, universe cheap.
Valuations across EM and FM appear to reflect a degree of stress, with respective price/book discounts of 10% and 15% relative to five-year medians, compared with the US S&P, which is on a 15% premium. And most individual EM countries are cheap relative to their own history.
The overall asset class is cheap relative to the US – where not only does the valuation of equities and currency look high relative to the historical average but there are also fundamental concerns on polarised politics and productivity.
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 export (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 rate suggests 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 that 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, India;
Mid-sized EM: Colombia, Indonesia, Peru, the UAE;
Small EM-Frontier: Bahrain, Iraq, Jamaica, Oman, Tanzania, Tunisia, 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
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.
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.
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:
Large EM: China and Brazil,
Mid-sized EM: Chile and Thailand, and
Small EM-Frontier: Vietnam and Kazakhstan.
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
Themes from the IMF/World Bank meetings (Culverhouse, Curran)
Colombia central bank not done yet as it hikes again (Culverhouse)
Peru hikes again as headline inflation eases (Culverhouse)
Lebanon is still a gamble (Curran)
Ghana to seek debt restructuring but details vague (Culverhouse)