INTERNATIONAL CONSULTANTS, INC. EST. 1987
After nearly two years, the global Covid-19 pandemic continues to weigh on economies worldwide. Uncertainty over inflation, monetary tightening, China’s outlook, global vaccine inequality, and supply chain issues are among top concerns in developed and emerging markets. As the latest Covid-19 Omicron variant spreads, the vaccine gap between emerging and developed economies is stark and will continue to slow a broad-based economic rebound. In the six years prior to the pandemic, emerging economies expanded 2.4%-points faster than developed markets, but the differential is now only just over 1%-point. The traditional year-end crystal ball gazing to predict the outlook for emerging markets is more difficult this year with interrelated growth and health factors still in flux.
Emerging market stocks lagged developed market peers this year with the MSCI Emerging and Frontier Markets Index down nearly 6% through end-November. Emerging market stocks are now 40% cheaper than US peers comparing price/earnings ratios. The disappointing stock market performance comes despite fund inflows of more than USD 105 billion, according to EPFR data, while bond funds have taken in half that amount. Equity market outperformers in dollar terms are energy producers in the Middle East, while laggards include markets where the currency plummeted on inflation spikes and “unorthodox” politics and policies, including Turkey and Brazil.
As investors debate possible US Federal Reserve and European Central Bank tightening next year, most emerging market monetary authorities are pro-actively responding to rising prices by hiking benchmark interest rates. Food and energy price spikes, along with supply chain issues, are driving up inflation. The UN’s Food and Agriculture food price index at end-November was up 27.3% on an annual basis. In emerging markets food accounts for an average 27% of Consumer Price Inflation baskets, about 10% higher than in developed economies. The combination of pandemic-related job losses and rising prices has not only hit economic growth in emerging and frontier markets, but reversed years of poverty reduction success.
Emerging market fund flows and equity market performance are skewed by China’s weight in indices. For equities it accounts for 42% by capitalization on the MSCI Emerging Markets Index. Similarly, the inclusion of China on the FTSE Russell index last year has sent foreign holdings of local bonds up 30% in 2021. Total foreign holdings of locally traded stocks and bonds issued in RMB topped the USD 1 trillion mark this year as emerging market ETFs and index trackers upped allocation despite the bumpy macro-economic environment.
Over the past few decades, foreign flows to emerging markets were largely driven by US Federal Reserve moves. When the Fed cut rates and released massive liquidity, foreign investors rushed to higher yielding, faster growth emerging market assets, while a rush to the “safe haven” USD occurred on a hike. Next year Fed watchers will consider taper/rate hikes, but for the emerging/frontier market universe the US monetary authority will no longer be the key driver for investment/divestment. It will rank with China and the spread/containment of the global pandemic as main decision-making factors.
China’s importance to emerging market trade and investment has surged the past decade through both through the Belt and Road Initiative and as the biggest trade partner for ASEAN neighbors as well as many Latin American markets, including Brazil and Chile. The world’s second biggest economy is slowing sharply on the crackdown on the private/technology sector, property market slowdown/developer debt issues, and lack of stimulus. In the decade following the global financial crisis, the world’s second biggest economy averaged annual growth of 8.8% after its massive USD 585 billion stimulus package announced in late 2008. While the OECD just projected that China will expand just over 5% in 2022, the 4% range is more likely.
Pandemic uncertainties and uneven vaccine distribution will also weigh on emerging and frontier markets in 2022. While some countries like United Arab Emirates, South Korea and Chile have vaccinated over 80% of eligible populations, the number is less than 10% in much of sub-Saharan Africa, including Kenya and Ghana, according to a Reuters database. While manufacturing has bounced back in many markets, services will remain subdued absent widespread vaccine rollout and cross-border travel unblocking.
Global inflation will also weigh on most markets next year, especially as the US Federal Reserve has backtracked on its “transitory” argument. Even if the price of oil continues to dip on the new Covid variant, global food prices will continue to climb on supply disruptions, factory closures and poor harvests in many countries due to drought, according to the UN’s Food and Agricultural Organization. While numerous central banks in emerging economies have already hiked rates in response to rising prices, continued tightening will further slow recovery.
Elevated debt and deficit levels are deterrents. After Covid related stimulus and spending, fiscal deficits have spiraled far beyond the 3% of GDP level seen as safe. While most developed nations have begun to remove Covid-related financial supports and will turn in lower, but still elevated, deficits this year and next, narrowing will take longer in the emerging market universe. Debt levels have spiked for many sovereigns. Currently four countries are in default on international obligations – Lebanon, Zambia, Venezuela, and Suriname – while nearly 10 countries have sovereign dollar bond with yields over 10%. At least two new defaults are expected next year in frontier markets Sri Lanka and Ethiopia. Yields on their bonds have spiked more than 10% this year, and their foreign reserves are inadequate to service 2022 payments. At the same time, the IMF is cautioning that local debt restructuring is expected to in emerging markets. Although locally issued government debt is largely held by domestic banks and investors, in some countries, like Peru for example, foreign investors still hold significant percentages of amounts outstanding. Local banks are already often in danger from double-digit bad loan ratios as virus repayment waivers expire before government securities are written down on balance sheets.
A heavy election cycle will also unsettle many emerging markets next year. In Latin America, where a shift to populism already started with Peru’s election of a left-wing outsider, Colombia will hold both congressional and presidential polls in the first half, while a new administration headed by either a far-right or leftist candidate will take office in Chile. In Colombia the current president cannot stand for re-election and a leftist senator is ahead in polls. Brazil’s election is already unnerving markets as it is likely that former leftist president Lula will challenge the current unpopular incumbent Bolsonaro as debt/GDP tops 90% and fiscal challenges mount. In Asia, the Philippines and South Korea will hold presidential elections in the first half, while polls are scheduled in Hungary and Serbia as well, with the ruling party’s majority in the former at risk of losing its grip on power for the first time in a decade.
Although the overall global picture is uncertain and gloomy, differentiating between markets and regions and stocks, bonds, and currencies offers a more optimistic outlook. Following the COP26 Global Climate Summit where emerging markets made ambitious new green commitments, with the caveat that advanced country pledges of financial assistance be delivered, alternative fuels will be a key area of interest. Technology-related/new economy sectors in every region will continue to attract investor attention, both in the traditional “tech-heavy” markets like South Korea and Taiwan as well as other emerging and frontier economies with younger populations.
By region, Latin America will again be the laggard as inflation weighs, debt builds, and increasingly erratic fiscal and investment policies shift under populist regimes. Externally, China’s lower appetite for the region’s commodity exports will hurt. In emerging Europe, Turkey’s interest rate moves and lack of institutional credibility will continue to bite, although as a mainstream sideshow with low index weights. The currency lost 45% against the US dollar in the first eleven months of 2021 after the central bank cut rates to 15%, even as inflation tops 21%. Poland and Hungary are battling rising inflation while a war of words over rule-of-law issues with the EU threatens needed cash infusions from the region’s recovery fund. Further east, investors will have to closely monitor Russia’s geo-political moves but will have fresh opportunities, including Uzbekistan’s ambitious privatization pipeline.
Consumer price inflation in Asia is generally more subdued than in other regions, and Asia-ex-China is likely to rebound as supply chain constraints ease, although elevated debt and deficits will continue to be a focus. India’s stock, bond and currency outlook is murky as it is particularly vulnerable to higher commodity prices and the potential of a Fed rate hike, after it outperformed most peers this year. China’s currency is the least likely to be hit by fund outflows due to inclusion in fixed income indices and continued capital controls, but the forecast for the stock market is uncertain due to both the private sector/tech company crackdown and increasing government presence in the corporate sector. Performance of the large Middle Eastern markets will be driven by global oil prices, although Dubai’s planned IPO pipeline will attract significant attention. Finally in Africa, economic, market and currency performance hinges on vaccine rollout and developed country funding for climate change, after lagging as a frontier index component this year.
In conclusion, macro-economic, stock, bond, and currency performance in the emerging and frontier markets will in 2022 depend on Covid variants and vaccines, China’s growth and economic/geopolitical policies, global food/energy price inflation, and potential easing of supply chain constraints. US Federal Reserve and European Central Bank tapering and potential tightening will also bear on performance. Rather than a wholesale global outlook for emerging and frontier economies, as a headline reflection of liquidity conditions, investors need to dive deep into underlying fundamentals. Historical comparisons from not only the aftermath of the Global Financial Crisis, but back to the rise of Latin America following the continent’s lost decade can offer baseline insights into vulnerabilities and pockets of strength. After more than three decades of analyzing emerging economies and financial markets, the annual crystal ball gazing exercise with Covid is unusually hazy but underscores a stock market revolution in technology, logistics, and sustainability, alongside traditional high-growth, generation leap segments targeting the younger, growing middle class.
