A shrinking room for error

The synchronized nature of the ongoing tightening in global monetary policy has little historical precedent. Just about every major central bank is raising interest rates, with the exception of China and to some extent Japan. This, together with the strength of the US dollar as the Federal Reserve moves more hastily than many of its peers, has made global financial conditions more restrictive.?

In addition, tremors are being felt across geopolitical fault lines. A prompt resolution to the war in Ukraine is unlikely, and US-China relations seem poised to worsen over time. Investors and businesses are having to grapple with tougher access to technology and capital markets. A case in point is the Biden administration’s recent stringent controls on artificial intelligence and semiconductor exports to China, or the fact that the word for “security” was featured 50% more than the word for “economy” in China’s Party Congress report.

In this context, nations and corporations are realizing that their room for error has meaningfully shrunk, with markets sharply reacting to the first signs of a policy mistake or balance sheet weakness. Given the drastic currency movements and interest rate repricing this year, foreign exchange and debt-maturity mismatches have become key points of vulnerability. The outsize volatility in UK assets in recent weeks is a clear reminder of this reality. If market stress can overwhelm the world’s sixth-largest economy—one with deep capital markets and ample access to funding—emerging markets should have no illusion that they can be spared.

Yet investors have been able to draw clear distinctions. Traders have wittily talked about the emergence of the “British peso” and the “Mexican pound,” recognizing Mexico’s proactive monetary policy, healthy external sector, and relatively stable politics. Colombia, in turn, has experienced an 10% depreciation of its currency against the US dollar in the last month alone, a reflection of its more vulnerable position.?

Investment implications

In aggregate, we expect a challenging investment outlook for emerging market assets in the next three to six months, with improved prospects looking a year out.

Despite trading at deeply depressed levels, emerging market equity valuations are unlikely to see a rerating in the near future. We expect earnings growth to become the key driver for emerging market stocks in this context. As economic growth slows, we see earnings rising by a very modest 3% this year and 4% in 2023, supporting low-single-digit equity returns through the middle of next year.

Valuations of emerging market bonds in US dollars are also baking in a fair amount of bad news, with the sovereign index yield now standing close to 10%. While we expect mid- to high-single-digit total returns for the asset class in our baseline scenario through mid-2023, investors need to be mindful that the range of possible outcomes remains large.

Where can investors find more attractive prospects?

Even in the face of possible election-induced volatility, the outperformance of Brazilian equities against emerging market peers should continue to be driven by still-high commodity prices, Brazil’s relatively low vulnerability to tighter global liquidity, attractive valuations that do not properly reflect prevailing and expected macroeconomic conditions, and high dividend yields. Within fixed income, a selection of short-duration bonds remains attractively valued and relatively insulated from the challenging global backdrop.

Co-authored with? Solita Marcelli

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