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Emerging Markets Took a Beating Last Year. Now They Could Be the Smart Play.
Lower valuations in emerging markets have been driven in part by the Chinese government’s crackdown on gaming, e-commerce, and education technology.
While developed countries enjoyed solid market growth in 2021, the investment landscape for emerging markets was considerably less rosy, with many locales still struggling to recover from the pandemic. In 2022, however, the big emerging markets are likely to play catch-up, presenting opportunities to global investors.
Last year, the MSCI Emerging Market Index was down 2.54 percent, while the MSCI World Index ended with a 21.82 percent annual return. But according to Vinayak Potti, portfolio manager at Insight Investment, some of the major emerging markets have been reacting “more proactively” to inflation pressure, which may help narrow the gap between the returns of EM portfolios and developed markets in 2022.
In a recent Insight report about emerging market debt, Potti and his colleagues wrote that unlike many Western economies, central banks in countries such as Brazil, Mexico, Russia, and Chile have all raised rates to contain inflation, a move that has helped create a substantial cushion against global volatility. “This hiking activity has helped anchor inflation expectations in many EM regions, reducing risks of capital outflows and financial instability,” the report said. “Rising rates have widened the yield premium in EM relative to developed markets.”
Hyung Kim, a portfolio manager and senior research analyst at investment manager Kayne Anderson Rudnick, said that from a historical perspective, the fact that the U.S. is preparing for rate hikes is not a positive sign for emerging market investors. This is because higher rates in the U.S. usually mean that developing countries with dollar-denominated bonds will have a harder time refinancing their debt. “But this time around, things may be a little different, because it’s not only the U.S. tightening,” Kim said. “With a lot of dollar reserves and better fiscal budget conditions, these [EM] countries are in a much better position to face an interest rate increase in the U.S.”
According to an EM outlook piece by Lazard Asset Management, the valuation discount in emerging markets has been partly driven by the Chinese government’s crackdown last year on companies with expensive valuations, especially those in the gaming, e-commerce, and education technology sectors. The report notes, however, that “Chinese companies are no stranger to the idea of government-mandated changes in their scope of operations and have a history of adapting to changes like the ones we have seen over the past year.” That kind of resilience means that the biggest emerging markets are still attractive to global investors.
Kishore Rao, a principal at the investment firm Sustainable Growth Advisers, agreed that the regulatory actions taken by the Chinese government have had a disruptive effect on the performance of emerging markets, but he cautioned that investors shouldn’t count out all Chinese stocks in 2022, because it’s still possible to “find the right set of companies that can grow earnings and cash flows” independent of major macro factors. For example, consumer staples stocks, especially those aligned with the carbon-emission goals of Chinese policymakers, have lots of growth potential in the coming months, Rao said.
Hyung Kim said that many investors are hesitant when it comes to aggressively investing in China. But the question for long-term investors, he added, should be whether China is still investible or not. Kim believes it is. “We still think China is a country where private businesses can prosper and many entrepreneurs can create value," he said.