Markets. Emerging markets Emerging market outperformance set to continue

But despite the recent rally, we believe that EM outperformance has further to run:

Peaking US inflation and a weaker US dollar are supportive of EM assets. While still considerably above the Federal Reserve’s target, US core CPI inflation dropped to 5.7% in December, down from a peak of 6.6% in September. As a result, fed funds futures markets are now pricing around a 95% chance that the Fed will further reduce the size of its expected February rate hike to 25 basis points. This downshift speaks in favor of fading Fed hawkishness over the course of the year, which is supportive of emerging market assets. The US dollar has started to depreciate, and longer-term interest rates have started to decline, thus helping to loosen financial conditions in many emerging economies.

China’s reopening to guide EM stocks higher. The rapid dismantling of COVID restrictions is paving the way for a faster-than-anticipated economic reopening in China, which bodes well for global growth prospects in 2023. However, MSCI EM is still trading at more than a 40% discount to developed market stocks versus the 10-year average of 34%. In our view, the implications from China’s economic recovery are not fully reflected in current valuations.

We expect EM stocks to deliver mid- to high-single-digit positive returns this year, and the MSCI EM index to end the year at 1,100, led by China’s economic reopening and the positive spillover effect into other emerging markets. We expect high-quality earnings growth leaders—such as internet and e-commerce companies—to outperform the broader MSCI EM benchmark. We believe Chinese stocks will outperform their global peers in 2023. Despite rallying over 50% from the trough in October, valuations are still appealing as the MSCI China 12-month forward P/E trades below its five-year average.

Tech remains a drag on US equities. Large-cap tech stock earnings have driven equity volatility this week, with the S&P 500 retreating after disappointing cloud sales from Microsoft, but rebounding on better-than-expected profits from Tesla. Overall, we expect fourth-quarter tech earnings to contract by 11%, largely due to a 26% contraction in semiconductors. At the broad index level, we do not believe that US valuations fully reflect the earnings contraction we expect this year.

So, we think selectivity will be rewarded, and our positioning reflects that. We incorporate a combination of defensive, value, and income opportunities that should outperform in a high-inflation, slowing-growth environment, alongside select cyclicals that should perform well as and when markets start to anticipate inflections in growth, inflation, and policy rates. We recently upgraded EM equities to most preferred. The risk-reward trade-off remains unfavorable for broad US indexes, in our view, and we retain a least preferred stance on US equities and the technology sector.

Main contributors - Mark Haefele, Patricia Lui, Michael Bolliger, Vincent Heaney, Daisy Tseng

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

Original report - Emerging market outperformance set to continue, 26 January 2023.