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Ashmore’s 2022 Emerging Markets Outlook

By Gustavo Medeiros

Ashmore’s Head of Research, Gustavo Medeiros, discusses the outlook for Emerging Markets in 2022. 

*This webinar is intended for Investment Professionals only. The content is provided for informational purposes only and should not be used as the basis for any decision to purchase or redeem investments in any Ashmore fund.

Transcript

Stephen Rudman: Good morning from me, Stephen Rudman. I’m a member of Ashmore’s New York City-based US Distribution team.

Welcome to Ashmore's 2022 Emerging Markets Outlook. Today's speaker is Gustavo Medeiros, Head of Research for Ashmore Group. Gustavo will give our review of 2021 and outlook for what we expect 2022 will bring. We will be discussing potential returns throughout the emerging markets space: equity, sovereign and corporate debt, as well as dollar and local currency.

Gustavo Medeiros: Thank you Stephen, for the introduction, and thank you all for joining the 2022 Outlook Webinar. First, we’ll talk about events in 2021, and the impact on 2022. We’ll also talk about four mega trends to monitor over the next year and discussing asset price performance across different interest rate cycles in the US Finally, we’ll go through Emerging Market (EM) asset valuations, and five-year scenarios for EM debt returns.

Now, there is no investment presentation that doesn’t start with a COVID overview. There’s little to say other than new milder variants like Omicron means the pandemic is very close to an end, fortunately. But the V-shaped recovery rebound last year wouldn't have been possible without the vaccines.

In terms of the percentage of populations now vaccinated with at least one dose, the larger EM countries (depicted by the upper middle income on the chart), are now fully caught up with developed markets, and had fully caught up with them by mid-2021. Close to half of the lower middle-income population, which is much younger in terms of demographic profile, is already vaccinated.

At the same time, in 2021 the world experienced a massive coordination failure. Rich countries started administering vaccine boosters before the populations of low-income countries recovered from their first vaccine dose. Therefore, we joined what we call the ‘endemic’ phase of the pandemic, which is likely to last for a little bit longer.

That said, the pandemic didn't change the big picture. GDP (in dollar terms) for EM countries has continued to outperform developed world growth, and the gap between EM and DM is likely to widen further from 2023. This is a notable difference from the 2013-2016 period when EM growth was fairly similar to the developing world: the chart on slide 5 shows the growth flatlining during this period.

Slide 6 shows the fiscal deficit remained extremely elevated across developing world countries in 2021. Not only did this feed the V-shaped recovery, but also the high level of indebtedness and surge in inflation demonstrated across developing world economies.

Last year, EM countries started consolidating their fiscal accounts faster than their developed market peers. Slide 6 shows the International Monetary Fund’s (IMF’s) fiscal deficit forecasts dated to October, so are a bit out of date. In our view, the fiscal deficit of EM countries was most likely below 4.7% of GDP in 2021, and EMs are likely to bring the deficit very close to pre-pandemic levels during 2022. Overall, debt to GDP increased by around 10% in emerging markets and around 20% in the developed world. We expect global GDP growth is likely to slow down in 2022 and 2023, but is likely to remain above pre-pandemic levels, thanks to higher saving levels across households.

The V-shaped recovery wouldn't be possible without the massive outperformance of Asian exports shown on slide 7. In only one year Asia gained 20% market share in relation to Europe and the United States’ supply chain, compared to a 0.5% annual market share gain in the previous five years. So, the global economy gained a significant boost from Asia, which is another reason for EM growth in 2021.

Of course, inflation was one the most significant side effects from the excessive fiscal stimulus. Since the third or fourth quarter of 2020 we had been expecting that inflation was likely to surprise on the upside, and indeed US consumer price index (CPI) inflation rose to 7%, significantly above the Federal Reserve’s inflation target, and also higher than EM inflation.

We expect inflation will remain elevated, as commodity prices today are some 9% above November 2021 levels. This will keep the year-on-year change in commodity prices at around 40% for the first quarter of 2022. The left-hand chart on slide 8 shows inflationary pressures are likely to stay at a relatively high level in the United States. Also, widespread pressure (due to supply chain disruptions) and higher wages (due to tight labour markets) mean we expect inflation is likely to remain elevated for much longer. You can see the labour market pressures on the left-hand chart on slide 9, and the ‘quit rate’ is a good leading indicator for wage inflation, which is now close to 5%, and likely to keep inflationary pressures high. The right-hand chart shows the supply and delivery times as measured by Purchasing Managers Indices across developed markets, still way below the 50 levels, suggesting significant lags in the delivery of supplies in the developed world – another element that complicates the inflationary picture. Higher frequency surveys suggest the delivery times of ships will remain elevated for slightly longer than policymakers anticipated, hence the Fed’s u-turn since the fourth quarter of last year.

As already touched upon, in 2022 we think the high level of household savings rates – not just the US but particularly in those countries that implemented high levels of fiscal stimulus support people during the pandemic – is likely to keep GDP growth in line with the growth picture that the IMF forecasted in October last year. We also expect to see inflation remaining above trend in 2022.

Now, let’s switch gears to talk about the future. We believe we're moving into a new macroeconomic regime which will have serious and important consequences for investment considerations. Over the last 30 years, developing world economists operated in a ‘Goldilocks’ environment most of the time: namely a combination of high growth (in GDP terms) and subdued inflation. From here, we think a few structural factors will likely bring us out of the Goldilocks environment, and investors will have to think about how to live with inflation.

For us, the risk is that policymakers do not adjust monetary policy, which would mean inflation remains elevated for longer, leading the economy to move into a stagflation scenario. Policymakers face a big dilemma: either they cool the economy to curb inflationary pressures, or they choose not to aggressively hike interest rates, meaning inflationary pressures remain elevated.

While we suspect policymakers are likely to, at the margin, opt to remain behind the curve, it is unlikely that the global economy will fall into stagflation either in 2022 or in 2023, as growth remains buoyed by high saving rates. We just want to highlight four trends that signal the movement towards the new macro environment.

Low real interest rates: The first trend is low real interest rates. A 2020 paper published by the Bank of England revealed a truly “supra-secular” decline in the level of risk-free real interest rates that dates as far back as the 14th century. In our view policymakers will not try to fight this trend in the next few years, due to the fact that high level of sovereign debt will demand zero, or in fact negative levels of real interest rates over several years in order to slowly but continuously erode the debt, or slow the debt via a policy of negative interest rates. In fact, ten-year interest rates priced on the TIPs (Treasury Inflation Protected Securities) market is today at -0.75%, and we do not see these interest rates exceeding 0% in 2022.

Reversal of inequality: The second key trend is the reversal of inequality. All governments are today committed to ending, or working very hard to reverse, the massive wealth inequality that has been accumulated over the last 40 years. China is working on its common prosperity policy, and the US is working to “build back better”, in the UK, we have the “levelling up” of society, and even Japan is working to implement some sort of universal basic income.

Wealth inequality has been a very deflationary trend, because aggregate income has shifted way from people with massive needs and willingness to spend, in favour of the rich, who have a much higher propensity to save money. So, that leads to less demand for commodities, consumer goods and durable goods, and more demand for financial assets.

Clearly, less demand tends to drive prices down in general, while a higher demand for financial assets would boost asset prices or financial assets. So, in our view, the reverse of inequality would potentially boost demand for commodities – boosting demand for consumer and durable goods, and lowering the margin demand for financial assets. This would be an inflationary trend and, again, be very different from what we have experienced over the last few years.

The energy transition: The third theme likely to generate inflationary pressure is the energy transition. Over the last 20 years, China and other Asian countries not only added very cheap labour to the global workforce, but also used very cheap energy to capture manufacturing market share from the rest of the world and bring it to China and the Asian supply chain. It was a strategy that proved very successful for two decades and even more successful recently in 2021. Today, China is fully committed to limiting the effects of climate change and lowering domestic pollution levels. China’s cheap energy was very much reliant on burning coal, a high contributor to pollution but also an extremely reliable and low-cost source of energy.

We believe that higher dependency on renewable energy across the world could lead to more unstable energy prices, to the extent that wind and solar energy are considered less trustworthy as a source of energy, given their dependence on climate as a factor required to  generate the electricity. This bodes well for large net exporters of energy, to the extent that the massive underinvestment witnessed in energy over the last 15 years, alongside with the urge to accelerate the transition to renewables, is likely to lead to higher and more unstable energy prices over the next years.

Tech regulation: The fourth theme is tech regulation. In this respect, China started way ahead of every other country in terms of regulating its technology sector, and today has a very thoughtful tech sector regime in place. This is now very much baked into asset prices valuations, with Chinese tech companies trading at a massive discount to their yet-to-be-regulated US peers.

As we’re talking about China, it’s worth looking at some of the most important issues for China in 2022. First, as the top right chart on slide 15 shows, China's productivity rates are best in class, due to its excellent educational system and phenomenal work ethic, which means it is unlikely to change. The bottom-right chart shows the People’s Bank of China (PBOC) was the only central bank committed to reducing the size of its balance sheet as a percentage of GDP, making it an exception in the world today. The bottom left chart shows that in renminbi terms, the PBOC balance sheet almost stagnated from 2015. And, over the last six years, China’s balance sheet expanded by only 2% per year against nominal GDP growth of 10%. So, in six years, China has been implementing quantitative tightening, something that we're likely to see in the US in a few months’ time. Also on this slide, the top-left chart shows how tighter monetary policy conditions have managed to contain asset prices quite well.

In terms of China’s real estate crisis, the big question is whether China can avoid the post bubble fate of both New York, where prices declined but then recovered, or Tokyo, which has suffered a permanent decline. China certainly has the policy tools to backstop the real estate crisis in our view, especially given how tight monetary policy has been kept in China. Perhaps Chinese policymakers are waiting for the right moment when they can ease monetary policy without affecting their strong renminbi policy, which would explain the relatively tight monetary conditions during 2021.

In a nutshell, we believe EM assets are poised to outperform in 2022, despite the upcoming Fed tightening cycle. We expect three interest rate hikes in 2022, most likely starting between March and May, and the Fed will likely start reducing the size of its balance sheet by the second half of 2022, as indicated in the most recent meeting minutes from the Federal Open Market Committee. In fact, even if the Fed raises rates a further four times in 2023, we believe real interest rates will remain very depressed, which doesn't bode well for the US dollar.

It might be counterintuitive, but EM asset prices managed to outperform during previous rate-hiking cycles, as shown on slide 17. Furthermore, EM central banks are already ahead of the curve, as most are today running current account surpluses, or small deficits. This means they will mostly likely be able to ease monetary policy (China is expected to do so aggressively in 2022 and other EM central banks are likely to do so towards the end of 2022 or early 2023).

The other key point here is that EM currencies appear deeply undervalued, then commodity prices are rising today to support the credit worthiness of commodity exporters, and finally foreign investors still have very light exposure across emerging market assets.

EM currencies also remain very attractive with real effective exchange rates only 8% above their 20-year low. Also, many exporting EM countries have been hoarding dollars abroad and not converting to local currency. For example, Brazilian exporters are hoarding about $70 billion overseas. The Brazilian real has been broadly stable over the last 12 months, making local currency bonds very hard to resist indeed, especially considering underlying inflation in Brazil is likely to halve from 10% currently to 5% in 2022. So, if exporters start selling the dollars that have been hoarded across EM countries, EM FX is quite likely to rally, in our view.

The flipside of cheap EM FX is obviously the expensive dollar. Last year, the Greenback rose, despite the US economy moving to a staggering 15% twin external and fiscal deficit. Even after the current year fiscal consolidation, those twin deficits are still likely to remain at high single-digit levels, consistent with a much weaker dollar. On slide 20, the left-hand chart shows the US has a $14 trillion net liability against the rest of the world. In other words, the difference between US assets owned by foreign investors, to foreign assets owned by American investors, today adds up to 65% of US GDP. Therefore, as the Fed starts hiking interest rates, we expect the dollar will weaken.

From an asset price perspective, US exceptionalism today is dependent on continuous inflow to US equities. Foreign investors today hold $12 trillion of US stocks, at mind-boggling levels. With a tightening cycle ahead, US stocks are most likely to suffer some sort of de-rating, making US stocks not really the right asset class to own. Second from a fundamental perspective, the US is nearing the end of pro-cyclical monetary and fiscal policies that started in earnest when Donald Trump cut corporate tax during the economic expansion in 2017. These pro-cyclical policies had a second leg after Joe Biden granted a second year of ‘free money’ to families during the pandemic.

We may find ourselves in a situation where the dollar weakens no matter what the Fed decides to do. If the Fed hikes rates slower than priced, US stocks will rally, but global stocks should outperform – to the extent that the dollar sells off due to unfavourable interest rate differentials. But if the Fed decides to hike rates higher than what’s priced in, US stocks would be expected to derate much more, leading foreign investors to sell US assets and therefore weakening the dollar. Furthermore, the European Central Bank (ECB) is turning more hawkish, with several ECB members talking about inflationary pressures – which is likely to compress the interest rate differential between Europe and the U.S., particularly after adjusting for inflation.

Slide 21 shows our five-year scenario for EM asset prices, considering three scenarios for the global economy: base case, bull market case and bear market case. With the base case, we have ten-year US Treasuries widening to 2.05%, leading to a flattish total return in annual terms. In the bull case, the ten-year US Treasury should widen to 3.23% over the next five years, leading investors to lose 2% per year from now until about 2026. In the bear case scenario, we assume the ten-year US Treasury rallies to zero, which would translate into a 4% annualised total returns for US Treasury holdings.

Now, we used the same bull, bear and base case scenario to calculate the total return for sovereign and corporate debt in emerging markets. EM sovereign debt, for example, , should return about 4.5% per year in both the base and bull market scenarios, as the high carry leads to a pretty good total return. In the bear case scenario, we assume a 500 basis points credit spread widening which is similar to what we've seen during the COVID sell-off. That will translate to a return of -1.7%, and that is also incorporating about 1.25% of defaults in the asset class every single year.

EM corporate debt should return around 3.5% per year in the base or bull case, down to the fact that it starting yield is lower than sovereign at 4.6%, and also credit spreads are tighter so there's less room to tighten here as US Treasuries widen. In the bear case scenario, we factor very high losses of -4.25% per year. This bear case presents the very unlikely scenario of five consecutive years of losses, leading to negative total returns of about 2% per year.

Local currency bonds are likely to outperform across the three scenarios, returning 5% per year if EM FX is unchanged. Double-digit levels of 10.5% per year if EM FX rallies 25% from here to the next five years, and even small positive returns in the scenario where EM FX sells off another 22% from here, which would obviously bring EM FX to new all-time lows both in nominal and real terms.

Slide 22 shows we also think EM equities are quite likely to outperform their global peers. Today, the price to long-term earnings (or price divided by the ten-year trailing earnings of the MSCI EM) is almost half the level of the S&P 500. With MSCI EM price to earnings around 20 times, whereas the S&P 500 is around 38 times its previous ten-year earnings. This is the so-called Robert Shiller indicator, which isolates price to earnings considering the point in the economic cycle. If we're seeing excessive earnings in the last two or three years and forecasting very, very high earnings, or pricing the markets to perfection in the next year, this ratio does a good job at bringing us back to reality.

In our view, the largest discount in 15 years in emerging market assets is unlikely to be sustainable. Slide 23 shows the major derating on evaluations of EM equities that took place during 2021, which saw them trading from 15 times 12-month earnings down to 11.5 times. We believe that EM earnings are likely to keep expanding in 2022 which – alongside undemanding valuations – makes it very hard for EM assets to underperform their global peers. In fact, the stock markets from large commodity exporters like Brazil, Russia, and South Africa, should be trading at much higher levels, particularly considering the strong terms of trade.

In summary, emerging market assets were under pressure in 2021 due to US exceptionalism, the fear of the Fed hiking policy rates, and the Chinese economy slowing down due to its twin real estate and energy crisis, as well as regulation impacting the price of Chinese equities. In 2022, on the other hand, we see the global macroeconomic environment looking ripe for EM asset price outperformance.

Not only will China be easing both monetary and fiscal policy, but we're also likely to see the end of US equities exceptionalism, and the Fed hiking interest rates, placing that fear into the rear-view mirror. Also, market participants started the year positioned for another year of US asset price outperformance, leading to a strong discounts of EM assets compared with the US and other developed world peers. This leaves plenty of room for positive surprises in EM asset prices.

 

 

 

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