Global Economy, Markets Key catalysts signal upside potential for emerging markets

Developed market high yield debt has outperformed EM bonds as well. In addition, with Chinese stocks facing renewed pressure recently, some investors may be reluctant to invest in EM assets—especially equities because they are cautious on the outlook for China.

But we think first half underperformance masks upside potential for EM assets, and we expect a turnaround in the months ahead.

Policy stimulus should support China’s economic recovery. With economic momentum weakening in April and May, policymakers in China appear to be shifting back into stimulus mode.

At the World Economic Forum held in Tianjin this week, Premier Li Qiang said that China’s economy is on course to achieve the growth target of around 5%and promised further steps to boost growth. “We will launch more practical and effective measures in expanding the potential of domestic demand, activating market vitality, promoting coordinated development, accelerating (the) green transition, and promoting high-level opening to the outside world,” Li said.

In our view, a series of targeted measures should help sustain GDP growth of 5–5.5% for the full year, and strengthen earnings and investor confidence. With China’s roughly 32% weight in MSCI EM, we believe this should buoy returns for the broader index in the coming months.

EM earnings growth may outpace DM in part due to a more advanced tightening cycle. Many EM central banks raised policy rates more swiftly and decisively than DM policymakers to check rising price pressures. Prior policy decisions are now bearing fruit, as EMs today appear ahead of their DM peers in taming inflation. In this environment, we have revised higher our EM earnings forecast for next year (13% vs. 7% for developed markets), and we see current valuations as attractive with EM as a whole trading at around a 46% discount to developed markets on a 12-month forward price-to-book (P/B) basis.

EM bonds weathering challenging times well. We see value in EM sovereign bonds, where valuations are attractive relative to historical levels driven by the high yield space. We think this segment's valuations incorporate a more challenging growth environment, while offering upside on prospects for a weaker US dollar and higher oil prices. In particular, we see opportunities in some larger issuers that are willing and able to work with the International Monetary Fund or other international lenders, or where we see upside to potential restructuring scenarios.

So, we remain most preferred on EM equities (and Chinese equities in our Asian strategies), and EM sovereign bonds. We also believe investors in emerging markets should consider environmental, social, and governance (ESG) leaders for their ability to mitigate downside risks and for their attractive valuations.

Main contributors - Solita Marcelli, Mark Haefele, Vincent Heaney, Jon Gordon

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

Original report - Key catalysts signal upside potential for emerging markets, 29 June 2023.