Four “Cs” Scramble 2022 Allocation Alphabet
This century and since the 2008 global financial crisis in particular, foreign portfolio flows to emerging markets have been largely driven by US Federal Reserve moves. Rate cuts and liquidity release send foreign investors to deploy funds in higher yielding, faster growing emerging market assets. With hikes global investors rush to the “safe haven” USD. Next year four “Cs” will dictate emerging market growth and market/currency performance and overshadow Fed tapering/tightening: Covid, Consumer Price Inflation, China, and Climate Change.
The biggest uncertainty is Covid as the latest Omicron variant spreads around the globe. The vaccine gap between developed and emerging economies remains stark and will slow a broad-based economic rebound. Even assuming only China retains a “zero Covid” strategy of city-wide lockdowns, the continued spread and virus mutations will stymie a rebound. Prior to the pandemic emerging economies as a universe grew faster than developed ones, expanding 2.4%-points more but the differential has narrowed to just over 1%-point. Growth will remain below potential in countries lacking vaccine access and distribution channels.
Consumer price inflation will also slow economic expansion as consumers and business are hit with higher prices. Most emerging market central banks – with the notable exception of Turkey – are pro-actively hiking benchmark interest rates in response to inflation driven by food and energy and supply chain disruptions. Globally food prices in the 12-months through November soared 27.3%, according to the UN’s Food and Agricultural food price index. Food accounts for an average 27% of CPI baskets in emerging economies, about 10% higher than in developed markets. For example in India, food and beverages account for almost half of the combined urban and rural CPI basket.
China will continue to skew the average emerging economy growth and performance data. The world’s second largest country has on outsized weighting of 42% by capitalization on the MSCI Emerging Markets Index. Similarly, its inclusion in the FTSE Russell index last year has sent foreign holdings of local bonds up 30% this year. Despite the uncertain macro-economic environment and private sector/tech company crackdown in recent months, foreign holdings of stocks and bonds issued in RMB topped USD 1 trillion this year as ETFs and index trackers upped allocation. In November alone, two-thirds of flows to emerging market debt went to China while more than 50% of equity inflows were allocated there, according to the Institute of International Finance.
The broader economic slowdown in China will heavily impact emerging market peers. Its importance to trade and investment has surged the past decade 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 “common prosperity” drive, continued crackdown on private/tech sectors, and property slowdown/developer debt issues will slow growth. The PBOC’s December 50 basis point cut in bank reserve requirements, freeing up USD 118 billion, is inadequate to restart strong growth. China’s USD 585 billion 2008 stimulus package drove average annual GDP growth to 8.8% in the decade after the global financial crisis. The OECD’s December projection that China will expand just over 5% in 2022 is optimistic, with a 3-4% range more likely absent significant new stimulus or policy changes.
The final “C” is climate change and ESG more broadly. Debates over corporate and sovereign investment will continue as investors globally question whether it is better to have “a seat at the table” to drive progress in sustainability or if it is better to not invest/divest. Countries with known human rights abuses like Belarus, already subject to sanctions, are increasingly likely to be shunned as ESG commitments are adopted. At the Glasgow COP 26 Global Climate Summit emerging markets made ambitious new commitments. With the commitment to “E” as ESG being adopted worldwide, global investors will favor alternative energy, tech-related/new economy sectors in both the traditional “tech-heavy” markets like South Korea and Taiwan as well as other emerging and frontier economies with younger populations. This year African tech start-up have raised at least a record USD 2.5 billion according to tracker Briter Bridges, and $4 billion in a separate data base as countries with younger populations are “skipping” intermediate stages of in many industries. For instance, in financial services many jumped directly from being unbanked and instead directly adopted fintech. At the same time, exchanges and market regulators are moving toward requiring and standardizing ESG disclosure, as Nairobi announced last month.
The 4-C drivers combined with the traditional US Federal Reserve moves impacting the global liquidity situation will be key factors in macro-economic, stock, bond, and currency performance in emerging and frontier markets in 2022. Of course basic macro-economic fundamentals like debt and deficit levels will remain critical to examine but there will not be a wholesale wave of flows into or out of emerging markets on US Fed moves. Instead, investors will need to differentiate between countries and fully analyze underlying fundamentals with more decision-making factors to consider. Historical comparisons dating back to the recovery of Latin America after its “lost decade” of the 1980s can offer insights into risk/reward opportunities. The impact of Covid and CPI on emerging and frontier markets will remain uncertain through next year, but the pandemic-era focus on technology and sustainability will offer fresh opportunities for asset class reinvention.