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Thought of the day

Emerging market equities struggled in February, with the MSCI index losing 6.5% on the month. That erased most of the 7.9% total return for the first month of the year. China was hit particularly hard with a negative return of 9.9%, leaving the index up just 0.7% so far in 2023. Emerging markets are especially vulnerable to the risk of an extended series of rate rises by the Federal Reserve and to a rising dollar—which adds to the burden of hard-currency denominated debt and tightens financial conditions.

But March got off to a better start, with a 1.4% gain in China’s CSI 300 and a 4.2% rise in the Hang Seng Index. We expect a renewed period of emerging market outperformance.

China’s economic reopening is starting to pay off, with improving business activity. China’s official manufacturing Purchasing Managers’ Index reading unexpectedly jumped to 52.6 in February, pointing to the fastest pace of expansion in more than a decade. The survey was higher than both the January 50.1 reading and the consensus forecast of 50.5. The period reflects the up-shift in the Chinese economy after COVID-19 restrictions were removed. The production subindex surged to 56.7 from 49.8 in January, reflecting a sharp uptick in business activity, while new orders rose to 54.1 from 50.9 in January, with both export and import orders in expansionary territory for the first time in nearly two years.

The service sector also picked up speed. The non-manufacturing PMI jumped to a 23-month high of 56.3 from 54.4 in January, with a continued recovery in services and construction amid solid infrastructure spending.

The pickup in China should increasingly boost growth elsewhere in emerging markets. We expect China’s reopening to spur domestic consumption, which should benefit China’s neighbors in North and Southeast Asia as well as several commodity-sensitive emerging economies such as those in the Middle East, Africa, and Latin America. On the corporate front, we have already seen earnings momentum and estimate revisions in emerging markets bottoming both in absolute terms and in relation to developed markets.

Emerging market equity valuations look appealing. On a price-to-book (P/B) basis, the MSCI Emerging Markets index is trading at a 43% discount to developed markets (12-month forward P/B at 1.5x versus 2.4x for MSCI World), a level historically consistent with a relative positive return over the medium term.

So, we think the broader EM rally looks likely to resume after a risk-off move in February. We remain most preferred on emerging market equities, including China, in our global strategies. Within Chinese equities, we like the direct beneficiaries of reopening, including sectors such as consumer, materials, and transportation. Within currencies, we remain positive on the Chinese yuan as well as China reopening beneficiaries like the Australian dollar and the Thai baht.