From Poland to India: Our 2023 outlook for emerging markets equities

GS: First and obviously, we need to express our wishes that the war ends as soon as possible. With regard to markets, the war is taking its toll. Valuations in Eastern Europe are quite depressed. However, economic growth has been quite strong despite the war and higher energy prices, as these economies have been benefiting from the post-COVID reopening and the low base of 2021. For example, Hungary and Poland are expected to grow by around 5% this year. 2023 is likely to be a bit more challenging, given record high inflation and hence declining real incomes. But it seems that a recession can be avoided.

Looking ahead to 2024, growth should be back to a level closer to 3%, which is in line with the region’s structural growth potential. The situation is better than we would have thought at first, given the war and pressures on the market. This is also thanks to increasing financial support from the European Union (EU), which may represent up to 3% of GDP in the countries mentioned above in the coming years. As for Poland, the significant number of refugees from Ukraine, who have been well integrated, has had a positive impact on the labor force supply, which had been constrained in the last couple of years. All in all, while the overhang from the war is still there, the economies are in relatively good shape, given the circumstances.

GS: While we hope that would be the case, it is still too early to talk about a resolution. The conflict could last well into next year, or in some form even beyond 2023, to be realistic. But on the other hand, we cannot completely exclude a major de-escalation in the near future. If and when there are signs of an end to the conflict, this could have a significant impact on our asset class as well as the global markets.

First, the commodity price shock that emerged after the breakout of the conflict in February could reverse. Energy prices could decline, especially those of gas or coal. In the case of oil prices, the impact is less clear, given that the improved supply situation in this scenario might be balanced by increased demand given an expected economic rebound. Second, food supply concerns could ease, reducing the pressure on food prices. As a result of these two factors, inflation might undershoot, which could allow central banks to relax monetary policy earlier and faster than expected. And last but not least, the uncertainty with regard to energy rationing in Europe, which is now quite severe, could decline. This could support the European economy and hence as well the global economy. The probability of this positive scenario is not zero, and we are keeping that in mind when constructing our portfolios.

GS: The impression of Saudi Arabia was quite good. I was positively surprised by the changes happening there. Saudi Arabia’s economy and society seem to be undergoing a profound transformation. Women have more freedom as major restrictions are being relaxed on voting, driving, employment, dress code and travel abroad. This is leading to stronger participation by women in the job market across public and private spheres. Businesses are no longer closed during prayer times. The special police who were enforcing these strict norms in the past have been dissolved. During my stay, I saw hardly any policemen patrolling the streets. Before, there were no cinemas in the country. People had to go to Dubai or Bahrain to watch films. Now cinemas are opening everywhere. This all sounds trivial for us, but for the Saudis, these are major changes. Younger Saudis sound quite optimistic about the future, given all these changes are improving their lives.

GS: Yes, the country is still benefiting at the moment from high oil prices. But the economy is definitely getting a boost from this social transformation. Consumption and the service sector are booming as a result. The economy should be supported by a significant investment program that could be worth more than a trillion dollars by 2030. There are also big investments planned into the renewables sector, building solar energy or green hydrogen projects. Both the shorter and longer term outlook for the country seem quite encouraging.

GS: The economy this year has been performing better than expected, thanks to falling unemployment. As a result of an early monetary tightening, inflation has already come down and is expected to end the year at mid-single digits. This is well below what we are seeing in the US and Europe nowadays and that is unusual in history. We haven’t had such low inflation in Brazil for a long time. Looking ahead, Brazil might be one of the first countries to cut interest rates in 2023, which could help maintain the economic momentum into the next year.

GS: In the short term, there are indeed some uncertainties around the administration of the newly elected president, Luiz Inácio Lula da Silva, particularly with regard to fiscal discipline. Nevertheless, Brazil has a conservative congress and senate, which should serve as good balance to the left-leaning president. We expect to see relatively reasonable macro policies going forward, which would support Brazilian assets into next year.

But Brazil is a big and deep market, offering lots of stock picking opportunities, even if the macro picture should get somewhat blurred from this new election. If we look further out, the country should benefit from its vast natural resources and strategic assets, such as an abundance of fertile land and water, both of which are becoming increasingly important.

SC: The market has been extremely volatile this year, but China has done very well over the last 10-20 years. The economy has grown, the middle class has grown and the population is doing well. Over the last two years, we’ve seen the introduction of many regulatory changes that affected certain industries, and many stocks started to de-rate. While it is easy to link all this to politics, it is more important to understand the policy objectives that are behind the regulatory changes. Some of the new policies related to antimonopoly and overleveraging are designed for positive outcomes. One can disagree with the manner in which the policies were implemented, but it’s important to understand the intentions and not to link everything that’s happening in China to politics.

Most of the reports about the Party Congress were negative. This was reflected in the stock market, which is why China was the worst-performing market in the world in October. Most of the negative reports centered on the fact that the new members of the Standing Committee are all perceived to have personal allegiance to President Xi Jinping. But if we look deeper into the background of the members, one would find that many of them have worked from the ground up. They have extensive experience managing cities and provinces at various levels—and working with multinational corporations.

And the tone on COVID policy has changed. When the 20-point plan was announced, the market was initially skeptical because implementation at the local level was mixed. But most recently, there has been a strong effort to push local officials to follow these more relaxed policies. We will see what happens next as infections and hospitalizations rise, but we are encouraged by the changes and believes China is moving in the right direction.

The latest slate of policy announcements relating to COVID and the property sector suggest that the economy will be getting a lot more attention going into 2023. By staying focused on the changes in the operating environment for the companies that we invest in, and trying to understand the policy objectives of the regulatory changes from the eyes of the Chinese government, investors can find good investment opportunities going forward.

SC: The problem arose because leverage among the real estate developers was too high. There were a lot of speculative elements in the sector. The government’s policy objective is clear: they want a house to be a home. The policy objective of the regulations was to tamp down that speculative element.

But the problem came when the economy was slowing and confidence was somewhat low due to COVID. Demand started to fall off as a result of curtailed economic activities, which led to issues in the property sector. A new development project takes two to three years to complete. When the government cut off liquidity, the developers couldn’t make adjustments. As a result, we saw cases where construction projects had started but were not completed. And the homeowners stopped paying their mortgages, because they weren’t sure they would get their homes delivered on time or at all. This started to pose a systemic risk to the market, as well as social unrest from people making down payments and not getting their house.

Starting in the middle of this year, the government began to ease the liquidity situation for the property developers. They released funds to allow projects to be completed and homeowners to move in on time, so that people would continue to pay their mortgages. What they are not doing is to bail out the entire property market. They are allowing developers to raise funds again and to issue bonds, and they’re encouraging banks to increase loan limits to the sector. The better developers will get cash flow to complete their projects, survive and eliminate most of the risk to the market from the property sector. At the same time, the developers that are overleveraged, don’t have a strong brand, and are not well managed may go under. It will take time to resolve itself, but the objective is to ring fence any systemic risk that could spill over to the financial markets as a whole. We shouldn’t expect the property sector to be a driver for the Chinese economy in the next two to three years.

SC: India has always been a growth engine for Asia. India is a large and diverse economy that is very domestically driven. That creates fertile ground for companies to emerge and take advantage of the domestic situation in terms of population, consumption and investment. And we are seeing those companies rise up. These are the companies that provide good investment opportunities, but it requires sufficient boots-on-the-ground type of research to take advantage of these opportunities. With India, you need to understand what’s happening locally, understand the regulations, and learn what needs to be done to do business. That is where visiting, talking to the companies and having local experience is useful.

Over the last few years, the government has put in place certain initiatives to drive parts of the economy that were previously not doing well. For example, the manufacturing sector has not done that well. In the last two or three years, in line with what’s happening globally, there is an opportunity for India to benefit from the trend of manufacturing diversifying away from China. The government has put policies in place to take advantage of that and not let this window of opportunity slip. At the same time, other than China+1, maybe Europe+1 is something that has been talked about. Because of high energy prices in Europe, certain industries may need to relocate. India could be a good place for them to relocate to. We are very positive about India. The runway for India is very long..

SC: Implementation has always been something that we need to pay attention to, and which sometimes presents challenges. It’s important to know what’s happening on the ground, and to understand the company and the operating environment that they are facing. Also, because India is a net importer of energy, it is always vulnerable to changes in energy prices and currency moves. With the taper tantrum in 2013, as the US dollar went up, the Indian market started to underperform. The external balances such as current account and foreign reserves were not in good shape. But we believe that, compared to 2013, India is in a much better position now. You can see it in current account balances and other external balances. Despite implementation risk and macro risk, India is a market that we are very positive on long-term, especially with respect to the stock-picking opportunities it offers.