Investing in Emerging Markets?
Outlook and economic forecasts for Emerging Markets. Report prepared by Mark Haefele Chief Investment Officer, UBS Global Wealth Management.
Emerging Market Outlook
Emerging Markets (EM) growth may outpace developed markets thanks to a more advanced policy cycle. From the second quarter onward, market consensus expects Emerging Markets growth rates to accelerate relative to developed markets. And Emerging Markets purchasing managers’ indexes (PMIs) are already recording a stronger rate of expansion than developed markets.
Many Emerging Markets central banks were also quicker to raise policy rates than developed market counterparts to check rising price pressures. Prior policy decisions are bearing fruit. One example is Brazilian inflation falling to 4.7% in March, the first reading within the central bank’s target for more than two years.
Yields and Emerging Markets
Global drivers should turn from headwinds to tailwinds. US government debt costs, which affect Emerging Markets issuers’ ability to service USDdenominated debt, have fallen as market focus shifts from inflation to growth and financial stability. Yields on 2-year and 10-year US Treasuries lie 100 and 62 basis points below their 2023 highs, respectively. We foresee a weaker USD and flat-to-slightly lower US yields by year-end, as US interest rates peak and the country's growth differential with the rest of the world fades. Historically, these developments have supported Emerging Markets assets.
Chinese Economy and Emerging Markets
China’s economic recovery should translate into stronger earnings, pulling up emerging markets. China's first-quarter GDP growth of 4.5% surpassed both market expectations and the fourth-quarter print of 2.9%. Consumption data imply China’s domestically focused recovery is on track: March retail sales growth hit a near-two-year high of 10.6% year-over-year. And China’s property sector is showing signs of improved sentiment (construction PMIs have Market update Hang Seng Tech +1.6%, China tech up after overnight pressure. Nasdaq futures +1.3%, bid up after US mega cap earnings. UST 2-year yields –18.7bps overnight, amid regional bank and growth concerns. Brent crude oil +0.4%, back above USD 81 a barrel. What to watch: 26 April 2023 • US March wholesale and retail inventories • US March durable goods orders • Germany May GfK consumer confidence bounced) and activity (year-over-year growth rates in property sales are now flat).
Our GDP growth forecast of at least 5.7% exceeds the government’s 5% target, and we see overall earnings growth of 14% for Chinese equities. Chinese companies make up 32% of the MSCI Emerging Markets Index, so Emerging Markets equities should be well supported. Other ways to position for China’s recovery include the Australian dollar, commodities, and select European beneficiaries. Valuations across equities and fixed income underprice improved fundamentals. Emerging Markets equities are trading at 11.6x 12-month forward earnings, below the 10-year average and at a significant discount to US equities—a CIO least preferred market—at 18x for the S&P 500, the most in about a year.
Earnings for Emerging Markets
Meanwhile, forward earnings prospects for Emerging Markets equities should continue to improve, driving positive performance over the next 6–12 months. Our most preferred stance on Emerging Markets bonds is helped by higher starting yields (8.8% for sovereign USD debt) and appealing valuations. Today’s yield pickup of nearly 500bps over the US Treasury curve can make a significant contribution to investors’ ability to generate portfolio income, especially if held over longer investment horizons. Emerging Markets bonds also look fair to attractively valued when adjusted for credit quality and likely recovery values. On this basis, today’s 225bps risk premium for Emerging Markets sovereign bonds over US Treasuries—about 25bps above the 10-year average—implies that investors are more than compensated for underlying credit risks. Historically, buying EM sovereign bonds when risk premiums are elevated has led to above-average returns over a 6–12 month investment horizon. For more details, please see Investment strategy insights: “Ten reasons we like emerging markets” (published 21 April 2023).
Banking Sector and Emerging Markets
Caught our attention Banking sector concerns. The S&P 500 fell 1.5% and two-year Treasury yields declined 18.7bps Wednesday, amid continued regional banking concerns and a renewed focus on the US debt ceiling. A WSJ article quoted Dallas Fed President Robert Kaplan warning that smaller banks may tighten their lending to small- and medium-sized businesses, and that the Fed did not “fully understand” banking sector risks ahead. US Treasury Secretary Janet Yellen separately warned of an “economic catastrophe” if Congress were to fail to raise the government's debt ceiling. On the data front, the US consumer confidence index slipped to a nine-month low in April, with shortterm expectations deteriorating and consumers holding back on vacation and home appliance spending plans.
Our view: We've been warning that tighter credit conditions will likely hit growth in the US, and on a sector basis, we think a least preferred view on US financials remains appropriate. More broadly, tighter financial conditions, an anticipated decline in corporate earnings, and relatively high valuations suggest a challenging outlook for US equities. We see better risk-reward in high-quality bonds than in broad US equity indexes.
Europe advances on emissions
EU economies last week approved changes to regional carbon trading and emission rules, tightening restrictions on industrial pollution while increasing funds to speed the bloc's energy Daily Europe 02 transition. The EU Emissions Trading System (ETS) will now phase out free permits, expand coverage to shipping firms, and accelerate the overall planned decline in total EU emissions for 2030. Underscoring Europe’s emissions focus, France’s central bank chief François Villeroy de Galhau earlier this week said addressing climate-related risks was a “core business and core duty” for financial institutions. Our view: We think imposing a real cost on carbon is central to reducing emissions, and we anticipate continued legislative progress and generous industrial subsidies will offer tailwinds for companies involved in energy production, such as energy efficiency, clean air and carbon reduction, and renewables. With strong capital commitments from governments and businesses alike, we continue to believe that sustainability should be a key long-term driver of investment returns.