WEBINAR: Ashmore’s 2023 Emerging Markets Outlook
Ashmore’s Head of Research, Gustavo Medeiros, discusses the outlook for Emerging Markets in 2023.
Transcript is available below.
Ted Smith: Hi, I'm Ted Smith from Ashmore Investments. Welcome and thank you for joining us for this year-end outlook for 2023. This is an annual tradition with Ashmore, and we're glad to be joined by a long list of clients and consultants that we talk to on a regular basis.
Today’s topic is also the subject of a white paper that's already been distributed. If you have not yet received it, please reach out to your contact at Ashmore, and we'll happy to send it out to you. This webinar will also be distributed as a recording.
We are joined today by Gustavo Medeiros. Gustavo is our head of research at Ashmore, having been with us for more than 12 years. He sits with the investment committee and talks to the investment committee on a weekly basis about macro themes that affect emerging markets. So, Gustavo is well placed today to talk about what he sees on the horizon in 2023.
Gustavo Medeiros: Thank you very much, Ted, it’s a pleasure being here. Thanks everybody for dialling in or listening to the recording. Let's talk about 2023. Of course, it’s very hard to predict the future, but this is what we're thinking at the moment, and quite a lot of work that goes into that.
The first point worth highlighting is that we're going to get most likely a very strong growth outperformance in emerging markets (EM) versus the developed (DM) world. The left-hand side of the chart on the screen shows EM GDP growth is forecasted by sell-side research to increase from 3.4% to 3.6% between 2022 and 2023, whereas DM growth declines from around 2% to 0.1% only. So, the growth gap between EM and DM increases from 1% to 3.5%. If confirmed, that's going to be the largest increase since 2009.
On the right-hand side, you can see that even if the forecast from the International Monetary Fund (IMF) ends up being more accurate, we're still likely to see EM assets massively outperforming developed world assets.
Over the last 20 years, there has been a very strong correlation between the EM growth premium versus the rest of the world. You can see that by the ratio between MSCI EM to the MSCI EM world overlaid against the EM (-DM) growth premium according to the IMF forecasts. We prefer sell-side forecasts. Typically, we think the sell-side is more accurate. But again, the IMF has a much lower growth premium. And even if the IMF is right, we're likely to see a strong environment for EM. That’s led by China, Hong Kong, and Taiwan rebounding. Most analysts are forecasting that China's going to get out of its zero COVID-programme, which we think is also correct.
But we're calling 2023 a year of two halves because we have a very strong headwind coming from monetary policy and from global monetary policy, as you can see on this chart. We are trying to estimate here what would be the impact of monetary policy tightening on economic activity, and therefore the economic impact also on markets. On this chart, we've modelled a scenario where the manufacturing purchasing managers indices (PMI) declines from the current high 40 levels to around high 30 to low 40 levels. If that's the case, then the S&P 500 as a proxy for risk assets should go down to around 3,100 to 3,400, very far from the 4,000 levels that we're trading at today.
The left-hand chart shows the forecast compatible with PMIs going to around 38 to 42 levels in the manufacturing space. And on the right-hand side, this has a very strong and well-known correlation over the medium to long term.
On the quantitative tightening side, you can see that there has been a pretty strong correlation over the last two years between the size of the balance sheet of the Fed and risk assets. The Fed balance sheet also includes some important liabilities that are key to liquidity conditions in global markets, including the reverse repo facility and the Treasury General Account. You can see that risky assets have been pretty much following that. In other words, every time there is a spike in liquidity, a relief rally or a short-term rebound of liquidity, stocks also had a relief rally. The latest one was this relief rally seen in November to mid-December.
So, if the Fed keeps on tightening the liquidity conditions via quantitative tightening, that makes for a very tough environment. We believe that this environment and lower asset prices will at the end of the day lead to a recession. That's a very difficult environment for asset prices across the board. That's no different in emerging markets, and that's why we're calling it a year of two halves.
Now, if you're trying to find a place to hide, fear not. We have a solution for you. Investment grade assets most likely will perform in total return terms. We've been talking about that since the end of the second quarter of 2022. If you've been meeting with us, or talking to us over the phone or listening to our latest communications you'll see that we've been preferring investment grade thematically for global allocators that care about total return versus other parts of the asset class.
Obviously, that positioning served them very well to the extent that yields on US Treasuries have tightened from about 75 to 100 basis points from their highs in the 10-year space. However, we still think that this is a trade that makes sense, especially when you're looking at investment grade securities that trade at very wide level of credit spread, considering credit worthiness.
On the right-hand chart, you can see that EM corporates have about one times debt to EBITDA (earnings before interest, taxes, depreciation, and amortisation on average, and that compares with around 2.5 net debt to EBITDA when looking to the average investment grade corporates in the US. Therefore, EM corporates are much less leveraged than US corporates, and if you look at the dark blue line showing EM corporates, the line has been trending downwards. In other words, EM corporates have been deleveraging their balance sheets. If you look at the left-hand chart, you'll see that in the single-A and double-B and triple-B investment grade space, you still have very good pricing or very cheap assets when you compare with US securities.
It’s the same in the high yield space where single-B assets seems to be incredibly tight in the US and relatively wide in EM. But again, the high yield space is likely to be under headwinds if we do get a year of two halves, particularly if we get risk assets selling off at the beginning of the year as a result of the incoming recession.
When you think about broader sovereign debt in emerging markets, considering both investment grade and high yield, we think there is an opportunity for long-term asset allocators who need to allocate and don’t care about volatility over the next three to six months. Is EM cheap? The answer is yes, quite cheap. If you look at it quantitatively, every time the high yield part of the J.P. Morgan EMBI Global Diversified Index traded above 1,000 basis points over US Treasuries, you get extraordinarily high total returns within the next 12 months and three years.
Within high yield, the part of the asset class that is really cheap and really distressed is the triple-C or below. If we do get a recession, yield-to-maturity can widen on the single-B and double-B part of the asset class and therefore you can have a headwind facing the high yield part of the asset class. To the extent that triple-C assets are only 5% of the asset class, the single-Bs and double-Bs are about 45% of the asset class, which is a much larger part of the asset class, which is already distressed but not extremely distressed. In a nutshell, there is value, but you could have more downside if we do get an economic recession.
Here we have applied a total return scenario analysis across, as always, three scenarios. First, we have the scenario where we're going to have a mild recession that is consistent with PMIs getting to around 38 to 42 levels. In that scenario, we should see negative payroll numbers, at some point in the second half of 2023.
And at some point, inflation should decline to around 2-3% by mid-year. In that scenario, we think the Fed is going to do what they've been planning to do, hiking policy rates to around 5%, maybe a little bit more or less, it's a bit irrelevant in our view.
But then in a recession, the Fed is likely to start cutting policy rates. Here we model only a very marginal cut, three x 50 basis points to 3.5%, which we think is within the range of possibilities – and not far from the most aggressive or the most extreme range of possibilities on either side.
Then we model a soft landing where the Fed hikes policy rates to 5% but there's no recession and policy rates remains at 5% throughout 2023. We also model an over-tightening deep recession – you can call it the Jim Bullard scenario.
If the Fed hikes all the way to 6%, then at some point we're going to have a much tougher recession than what we model in the mild recession scenario. In that case, the Fed is probably going to have to cut more aggressively towards the end of the year. You can see what it means in terms of total returns for 10-year US Treasuries. So, on the mild recession, 10-year gets to 3.25%, in a soft landing, 4.5%, and in the deep recession scenario 2.75%. Then on the far right of the screen, you have the total return scenarios for US Treasuries, and then we have the same exercise for EM sovereign debt, EM sovereign investment grade, EM corporate debt and corporate investment grade, both in terms of credit spreads, levels, and then total returns.
A couple of interesting things here. First, in a mild recession scenario, investment grade outperforms the overall index. That's precisely why we think that in the first half of 2023, investment grade could be a good place to hide. I think that's the base case scenario we have at the moment. It may change as things evolve, but with the information we have today, that would probably be a safe bet in a mild recession scenario.
The other interesting element is that local currency outperforms dollar-denominated debt pretty much across the board. That's already incorporating a 7.5% currency depreciation from here in a deep recession scenario, or a 7.5% currency appreciation if you do get a soft landing and you get a scenario where a risk-on environment allows EM currencies to strengthen significantly.
We think it's interesting to the extent that it's been many years since EM local debt did not outperform the broader part of the asset class, but it's also been many years since the US dollar has been this much on the front foot. We believe we've probably seen the peak of the dollar already in 2022 and it's going to be very hard in 2022 for the dollar to make new highs.
So, this -7.5% selloff is a pretty difficult scenario to paint considering the levels of valuations and the distortions accumulated on the US external accounts, and how undervalued are the EM currencies versus the dollar.
I'll probably get a lot of pushback against this scenario given how the asset class has been performing over the last years. But we thought it was worthwhile publishing, particularly considering that the technical environment for EM local bonds is extremely favourable. EM markets are around 50% of the global GDP, total EM debt is less than 20% of global fixed income, and EM bond funds account for only 3.6% of global funds. So, you can see that particularly for the local currency part of the asset class, investors have been reducing the percentage of ownership of the asset class across all regions since 2013, pretty much. The exception to that was China, but investors have been selling Chinese bonds during 2022, as you can see by the red line on the chart on your slide right now.
Again, the technicals are very favourable for EM debt in general and in particular for EM local bonds, which I think corroborates some of our scenario analysis.
It's a similar story for EM equities. We have had an ambiguous year where we might have seen an aggressive Fed leading to a recession, but a recession would also make the Fed properly pivot. When the Fed pivots and start cutting policy rates, that is going to be a very strong tailwind for global equities. And, if China gets out of its zero COVID-19 strategy (and we assign a very high probability of that). The question is the timing of the relaxation of the measures and how quickly the Chinese economy rebounds.
We think it's going to be a complicated reopening during the winter, but it's going to be a much faster reopening from March 2023 onward.
This scenario, of the Fed potentially pivoting and China reopening, is a pretty strong scenario for EM equities. China is a large part of EM equities and China being buoyed by economic performance and trading at very cheap valuation levels, promises very high total returns.
But the Fed easing monetary policy should also be a tailwind across the board for emerging markets in general. The big question here is the scenario in Ukraine, and geopolitical risks more broadly, which is very difficult to forecast. But these two out of three scenarios are most likely going in the right direction, and are very strong tailwinds.
So, when you do the same base case exercise for equities, we get potential total returns of 18% and modelling earnings per share at $83 dollars per share, which is about $17 less than the peak of the consensus for MSCI EM that we got about a year ago. So, this is already a significant derating on the earnings per share and we have price-to-earnings bouncing from 11 times earnings today, to around 12.5 times earnings. So, some rerating allowing for these strong total returns obviously after adding the dividend yield of 3.5%.
On the bearish scenario, we think that the price-to-earnings derates further to 10.5 times and we'll continue to get an earnings recession. Here, earnings per share goes to $75. That's a pretty extreme bearish scenario, and total returns get to -17%.
In the more bullish scenario, we go back to the highest levels on earnings-per-share and price-to-earnings rerate to 12.5 times, which is around the average over the last 20 years for MSCI EM, So, not unfeasible at all. And you get 38% total returns. Therefore, we are very bullish in relative terms in emerging markets versus the rest of the world's stocks.
And in absolute terms, we think once this recession is fully priced, then buying emerging market equities becomes a bit of a no-brainer. It's very likely EM is going to outperform the turn of this cycle, given particularly that the former market leader, US equities, has been underperforming the vast majority of the world’s stock markets through 2022.
When talking about the recession, monetary policy is the key. This slide shows the reason why we think that given the very aggressive monetary policy tightening engineered by the Fed and now the ECB, and other central banks in the world, combined with the very high level of indebtedness. This this is not only government debt but also private sector and corporate debt that is extremely elevated across many countries.
It's quite likely that we're going to see a balance sheet recession and that translates in the private sector into a housing recession. You can see house prices already coming down in those countries that have the most elevated levels of private sector debt to GDP, like Canada, Australia, and Scandinavia. And we think this is going to deteriorate further, the longer policy makers keep interest rates at elevated levels. We also have very high levels of corporate debt to GDP in several countries like France, Canada and Sweden. We think that's going to be a very strong bottleneck as well.
But importantly, total debt to GDP is at extremely elevated levels when you put together household, corporate, and the private sector across the developed world, and we think that paints a complicated picture.
On the other side, if you look at the bottom of this table, you see that Mexico and Indonesia have the least levered balance sheets amongst the largest most important economies in the world. And it's not surprising that Mexico and Indonesia have been pretty much havens in terms of market performance when you look at the Mexican stock market and bull market in the Indonesian stock and bond markets, to the extent that again it has very low vulnerabilities considering the current cycle.
The most complicated questions will be asked by the 'bond vigilantes', asking if interest rates are that elevated, what does that mean for debt sustainability and what does that mean for debt service? Well, if debt service increases quite significantly within the next couple of years, in line with the increase of interest rates that we've seen in 2023 in the developed world, then that most likely means talking about a recession.
Corporations will have to slash costs, households will have tighter financial conditions and most of the private sector won't be able to afford the loans required to buy many assets - mortgages for our houses, for example.
Therefore, it's hard not to see a very difficult economic environment in 2023 after such strong monetary policy tightening across the developed world in 2022. And again, that reverberates in the year of two halves.
I think that the fundamentals are pointing to that direction so strongly that it has to be the view that at some point within 2023 or maybe 2024, we're likely to see a recession should policy makers not pivot. The Fed yesterday, the ECB, and the BOE today, gave no evidence of a pivot whatsoever looking to their actions or their languages.
So, in summary, global assets were subject to quite strong headwinds in 2022. But the headwinds for EM assets were zero COVID-19 and the real estate crisis in China, the aggressive interest rate tightening from the Fed and the Russian invasion of Ukraine. Two out of these three factors are very likely to turn from headwinds to tailwinds in 2023, while the Ukraine war remains highly uncertain.
We think that China has a strong local economy reopening during the spring, a stronger reopening of the Chinese borders in the summer. I don't think that the market is pricing that in at all. And the US economy is very likely to go into recession, forcing the Fed, not only to pause its hikes at some point in the first quarter, but to pivot to cuts in the second half of 2023. When the recession comes, there is going to be huge political pressure them to cut policy rates.
The more constructive scenarios for EM economies would allow EM assets to all perform DM assets over the next few years, despite the challenging environments for geopolitical risks and supply constraints.
So, we really like EM if you're an asset allocator that needs to be invested and you are trying to find relative value, We have a very strong conviction that EM offers fantastic relative value. If you're more concerned about total returns, then again, expect some headwinds in the first half of the year. Perhaps corporate investment grade in emerging markets is a pretty good place to hide. So, that's it. Let's see if we can have any questions from the audience.
Ted Smith: Okay, thank you Gustavo. We have several questions from our webinar attendees. The first is with respect to your comments that we're likely to see ever-tightening credit conditions, and likely to see a recession in the US. In your view, what does that mean for the most vulnerable countries within the emerging markets that are most dependent on foreign investment? What areas are you most concerned about in that first half of your analysis and how worried are you?
Gustavo Medeiros: Yes, I think the framework we've been discussing is one where you want to be selective in the high yield part of the asset class.
In particular, those countries that have high debt service costs, a high debt burden and elevated debt-to-GP, and have been dependent on the Euro bond market to finance their current account and fiscal deficits are in a very complicated spot. Especially if they are commodity importers, and if they depend on imports of grains.
This is still an environment where you want to be selective. A huge amount of countries will be under tremendous pressure if the war in Ukraine remains in place and if the Fed keeps policy rates tight at elevated levels. If you do get a recession, these countries will sell off in line with the broader risk spectrum.
So, as well as being selective in the high yield space, we think there is more value in the ultra-distressed part of the asset class. For example, Argentinian bonds are already priced in for a second default, while the part of the asset class that is not yet distressed, some of the single-B names that are trading at 80 cents or 90 cents on the dollar for example, could be relatively exposed to a disruption.
The commodity exporters are likely to remain as winners, particularly if we get a scenario of an economic recession where commodities prices don't collapse. . If OPEC+ keeps on their supply discipline and if the US decides to replenish its special reserves that have been dropped quite significantly over the last 12 months by the US administration. That could keep a floor of oil prices of $60 per barrel, $50 per barrel potentially, that would be much higher than the previous recession. This wouldn't be a tragedy for oil producers or exporters, so this part of the asset class could be protected.
I think that in a nutshell, you'll still want to be selective in the high yield space, in a recession, high yield typically sells off. This is an area where we have tremendous expertise and we typically do extremely well emerging from recessions. I don't think this time is going to be different. You should potentially expect quite a lot of volatility in our portfolios going into a recession, as we try to pick these winners versus losers. But then we should have a portfolio that is extremely well-positioned getting out of the recession into the second half of 2023 onwards, if we're right about this year of two halves.
Ted Smith: Thank you. Another webinar attendee is interested in the Russia-Ukraine conflict, which you've mentioned It's clearly a major factor influencing the fates of several countries and markets globally. Can you talk more about how that conflict enters into your analysis in the first and then maybe the second phase of next year?
Gustavo Medeiros: Thanks for the question. It's a very difficult one to predict. Our base case scenario for the next three to four months is that we're going to have a conflict that won't evolve significantly due to the winter in Ukraine, which is less severe than the winter in Russia, but it's still quite severe. This is also due to the fact that the Russians have caused severe damage to Ukrainian infrastructure, and as the Ukrainians have already managed to retake quite a lot of territory and they need to regroup to avoid spreading themselves too thinly.
We could be wrong, but we think these three factors most likely mean we’re not going to see a major significant change in the scenario this winter. However, come spring, we expect Ukraine is going to try to regain more territory, and that could lead to bigger tail risks. For example, if Ukraine managed to get close to retaking Crimea for example, that would be a major red line for the Russian regime. We would then expect a much more aggressive response from Russia, but also a higher incentive for both sides to to try to find a solution.
At some point it might make sense for Ukraine to play the long game, by freezing the conflict, or opting for a ceasefire, and trying to reconstruct Ukraine. A ceasefire would be the bullish scenario as quite a lot of supply constraints, particularly on the commodity side, could start getting unplugged. But it remains very difficult to forecast and our base case scenario for the first half of 2023 has to be a conflict similar to what we have today.
Ted Smith: Thank you. Another thread that you've mentioned through all of your scenarios is commodities, oil prices and how they impact the global economy. As we go forward in each of your scenarios, can you talk about what you expect for oil prices and commodities in the next year?
Gustavo Medeiros: Thanks for another challenging question. If you asked commodity analysts that live and breathe this market, they would say it’s a very ambiguous and complicated scenario. On one hand, in an economic recession, industrial commodities typically sell off. But on the other, looking to the medium-term, the energy transition is likely to demand a significant amount of industrial commodities, including copper and other metals, for example. So, we have this scenario where people are cautious about not taking too negative a position in the short term because of the more constructive medium to long-term environment.
In the energy space, you have the challenge of the energy transition alongside the geopolitical conflict, which is reducing the supply of energy coming from Russia, a powerhouse of energy. And if Russia is threatened in terms of losing Crimea, they could try to make life even more difficult for the rest of the world in terms of energy distribution.
So, in an economic recession, you'd expect oil prices to sell off, but OPEC+ has been very disciplined and Russia is a key player on this market, making this a more complicated, ambiguous scenario. I'm not surprised commodity prices have been much softer from May to date to the extent that we've had PMIs declining since then. While PMI levels have been consistent with a very shallow recession, the trend suggests we're going to keep on going towards a deeper recession. Therefore, commodity prices anticipating this trend makes sense to me.
It's going to be interesting to see what happens should we get a recession, the US decides to replenish its strategic reserves and Russia starts to play hardball in tightening the supply. If the rest of OPEC goes in the same direction, we could have very different behaviours in commodity markets than we had in the past, and much less straightforward behaviours. But overall, in the medium term, we are more constructive on commodities as we have been over the last 12-18 months. Simply speaking, there has been too little investment in commodities over the last ten years. The energy transition, together with the reversal of inequality over the last few years probably means we're going to have higher demand for commodities at a time that we have supply constraints in the commodity space. So, it’s an asset class that should have more tailwinds than headwinds structurally, in our view.
Ted Smith: Okay, thank you Gustavo, and thanks to all of you for your questions today. I just want to remind you once again that Gustavo has written a white paper on his thoughts for 2023, which is available on our website. You should receive an email with a replay of this webinar, but if not, please reach out to your favourite Ashmore business development professional. I'm sure they'd happy to send it along. Happy holidays and we'll see you again next year.
Gustavo Medeiros: Thank you, merry Christmas and happy new year everybody.