China's earlier-than-expected reopening looks set to boost domestic consumption and demand for goods and services from other emerging and developed nations. (ddp)

Emerging market assets could suffer further headwinds if the end of the Federal Reserve’s rate tightening cycle turns out to be further away than currently forecast.

But we now see a much more favorable backdrop for emerging markets.

Emerging markets are closely linked to the fortunes of the Chinese economy, which should rebound as the country opens up. China's earlier-than-expected reopening looks set to boost domestic consumption and demand for goods and services from other emerging (and developed) nations. Notably, we expect a revival in demand for energy and other commodities, on which many prominent emerging markets are heavily reliant. Structurally higher commodity prices should also cushion emerging economies and their credit fundamentals. Overall, we expect China’s growth to recover from 3% in 2022 to 4.9% this year.

Tactically speaking, China's reopening should both directly and indirectly benefit emerging market assets through brighter growth prospects, higher commodity prices, and improved financial conditions due to stronger currencies and lower interest rates. In addition, we expect the Chinese economy to contribute to an earlier inflection point in the global outlook. It is notable that the performance of emerging market equities has historically led an earnings recovery by almost three months.

Easing financial conditions and a weaker US dollar have historically been linked with strong emerging market performance. While the Fed is not yet done tightening and labor market data remains too strong, we still believe we are relatively near the end of the rate-hiking cycle.We also see further weakness ahead for the DXY dollar index, which even after a recent modest rebound—is still 9.5% down from its peak in September. In addition, we expect global economic growth to bottom this year and start to improve.

This combination of easing financial conditions, a weaker dollar, and a turn in growth has been positive for emerging markets in the past. Over the last 20 years, emerging market equities have produced annualized monthly returns of close to 43% in periods of accelerating growth and looser financial conditions, and around 23% even in periods of slowing growth and looser financial conditions.

Valuations are appealing on a relative basis and corporate fundamentals are turning the corner. At the time of writing, MSCI Emerging Markets is trading at 12x 12-month forward earnings, a small premium to its 10-year average. But that is still close to a 30% discount to developed markets. Earnings momentum and earnings revisions in emerging markets are still negative in absolute terms, but they are bottoming compared with developed markets.

So, we see emerging markets as well-positioned to be early beneficiaries of the inflection points in global markets, earnings, and GDP growth we expect in 2023. We are most preferred on both emerging market stocks and bonds. Among emerging markets, China is our most preferred market.

Main contributors - Mark Haefele, Michael Bolliger, Alejo Czerwonko, Christopher Swann, Jon Gordon

Content is a product of the Chief Investment Office (CIO).

Original report - Stars are aligning for emerging markets in risky environment, 9 February 2023.