Emerging market assets have underperformed developed market peers over the past decade. While this has led to valuation gaps, selectivity will be critical, argues David Nowakowski.

Read this article to understand:

  • Why China turning inwards could spell trouble for EM equities
  • The outlook for rates as inflation takes hold
  • The increasingly ugly political backdrop

The last decade has been difficult for investors in emerging market equities, which have generally delivered underwhelming performance. The 32 per cent return served up by the MSCI Emerging Market Index since the start of 2012 is barely a fifth of that generated by the MSCI World. Comparing price/equity ratios, the emerging market “discount” has grown from around 15 to 50 per cent in the past ten years.1

Figure 1: EM equities lag
Past performance is not a guide to future returns
Source Aviva Investors, January 2022. Data from Eikon Datastream, as of January 28, 2022

Much of this underperformance is down to a sharp deceleration in the rate at which the all-important Chinese equity market has advanced. Over the last ten years the MSCI China Index has returned 59 per cent, a miserly reward compared with the stunning 255 per cent of the previous decade.2 Part of the answer is the high returns, and unrealistically optimistic expectations for emerging market outperformance, that peaked a few years after the Global Financial Crisis.

Returns from local fixed income markets have simultaneously been disappointing. While this comparatively subdued performance by emerging market assets has arguably left valuations looking superficially attractive relative to developed markets, there are three good reasons for these valuation gaps to persist.

China is slowing

Whereas a booming Chinese economy was instrumental in lifting the world out of the recession that followed the financial crisis of 2008/09, Chinese economic expansion now is far more subdued. China’s economy was expanding in real terms by around ten per cent a year thanks to aggressive stimulus from 2009 to 2011. Now, output is rising at barely half that rate.3 Additionally, growth is widely expected to decelerate appreciably further in the coming years, to below five per cent per annum, as China struggles to fill the void left by a big slowdown in infrastructure spending.

The danger is that taxes on wealth or property hurt consumer confidence

China’s goal to shift activity away from infrastructure towards domestic consumption is nothing new. However, the strategy is proving far from straightforward to implement. Take the ‘common prosperity’ drive aimed at narrowing a widening wealth gap, which forms a key plank of Beijing’s strategy. With savings rates high and expected to remain so, it is unclear whether it will prove to be more than a mere slogan. At least in the short term, the danger is that taxes on wealth or property hurt consumer confidence.

At the heart of the difficulties is the country’s vast but bloated real estate sector, which has in recent years contributed almost 30 per cent of gross domestic product. It is so overbuilt, and companies so indebted, it threatens to relinquish its longstanding role as a prime driver of Chinese economic growth and, instead, become a drag on it. Evergrande, the world’s most indebted property company, is suffering a liquidity crunch that could lead to the demise of what just two years ago ranked as the world’s most valuable property stock. 

It is worth noting there has been some support recently for EM equities as Chinese authorities have provided liquidity and credit to businesses and, for now at least, eased up on the regulatory onslaught. However, concerns remain over the potential knock-on effects to the wider economy of the drive to cut high levels of leverage in the real-estate sector.

At the same time, China is increasingly looking to reorient its economy inwards. Although it is not abandoning its commitment to trade, Beijing announced a so-called dual circulation strategy in May 2020, which essentially updated its ‘Made in China 2025’ plan first outlined in 2015. China is aiming to vertically integrate production and achieve self-reliance, thereby insulating itself from the threat of natural resource bottlenecks and international embargoes of semiconductors and other key products.

Strong demand from China has helped drive a record-breaking surge in commodity prices

Strong demand from China, the world’s biggest consumer of commodities, alongside international spending on post-pandemic recovery programmes, supply disruptions and big bets on the green energy transition, have helped drive a record-breaking surge in commodity prices over the past two years.

However, it is unclear China will continue to import raw materials at the same pace – and certainly not at the same breakneck growth rate. Import growth had slowed for years before the COVID-19 crisis.

Although a slowdown in China could be bad news for companies and sectors heavily dependent on the country for revenues, developed economies, except for Germany, are far less exposed than their developing counterparts. China will be of much less help to the outside world, and emerging nations especially, than it was during the period that followed the financial crisis when it sucked in record quantities of various commodities for a sustained period and pushed out huge amounts of loans through the Belt and Road Initiative (BRI).

For example, China’s iron ore imports fell 4.3 per cent in 2021.4 While it would be unwise to read too much into one year’s figures, especially since 2020 marked a record year, some analysts predict further declines as China develops its own iron ore mines and attempts to boost scrap production. The shift away from property and infrastructure investment threatens to further depress demand. Meanwhile, the BRI loans to many poor countries have proved an albatross, failing to lift economic growth.

Investment may skew towards clean energy and decarbonisation

Investment may also skew towards clean energy and decarbonisation, which Chinese leaders hope will help the country dominate the global market for these technologies, but it could reduce coal and oil imports. This could be especially problematic for emerging economies, many of which are still heavily dependent on Chinese purchases of raw materials. Investors will need to be more rigorous in their analysis to determine those countries and companies that can either compete with China effectively or provide the key inputs it needs.

The inflation headache

Soaring global inflation, combined with a rapid deterioration in several nations’ fiscal positions, is presenting emerging market equity and bond investors with another headache.

Having already raised interest rates aggressively in 2021, there is a growing expectation many emerging nations’ central banks will have to tighten policy further as they battle rampant food and energy inflation.

Brazil is expected to hike by more than 1,000 basis points in total from a trough of two per cent

With price pressures outstripping interest rates, investors expect countries such as Brazil, India, Mexico, Poland, and South Africa to raise rates significantly over the coming year. For example, Brazil is expected to hike by more than 1,000 basis points in total from a trough of two per cent just a year ago. But overall, yields are still low for the asset class (Figure 2). Investors looking to outperform their respective benchmarks are likely to underweight duration, but patience is needed as strong total returns appear unlikely until the cycle turns and emerging market currencies begin to recover.

Higher rates are partly needed to defend currencies in the face of what financial markets are signalling will be a brisk tightening of US policy. While our central case is for higher-quality EM assets to weather the storm, Fed hiking cycles in 1994, 2018, and the taper tantrum in 2013 are all examples that exposed EM fragilities and forced defensive rate hikes. Without them, the risk is currency depreciation will lead to even higher inflation via imports.

The other rationale is the need to preserve both a nominal and a real yield differential over US Treasuries to prevent capital outflows. Capital flight could prove catastrophic given the damage done to many developing countries’ fiscal positions by the pandemic, and this risk may be growing as the Fed and other major central banks pivot to a more hawkish stance.

Higher rates will mean a rise in debt servicing and borrowing costs, which will be painful given the pandemic-era increase in debt burdens. Austerity might be a thing of the past for advanced economies, but poorer countries may still need it – and that will not be easy, or popular.

A wrong turn? Politics and geopolitics

Against this backdrop, there is a danger that political risk, which has to some extent been camouflaged by investors’ hunt for a pick-up in yield, begins to assume greater significance. This offers a third explanation for why investors are unlikely to be in a hurry to re-rate emerging market assets.

In 2021, Chile and Peru voted in left-of-centre populist governments amid widespread public anger at inequality, rising prices and the economic impact of the pandemic. Three years earlier Mexico did the same, and Colombia and Brazil could be set to follow suit in 2022. Argentina is a case apart, facing unsustainable debts and on the brink of default.

It remains to be seen whether governments bow to growing pressure for increased social spending. Should they do so there is a danger this would be badly received by investors, especially if politicians were to pressure central banks to refrain from tightening monetary policy.

Political risk, which has been camouflaged by investors’ hunt for yield, could assume greater significance

Rising political risk is not confined to Latin America. In Europe, Russia’s efforts to destabilise Ukraine’s democracy and economy could have serious implications for investors in a number of markets.

Meanwhile, Hungary and Poland are taking an increasingly confrontational stance in their dealings with the European Union. That could lead to the EU holding back billions of euros of recovery funds and even blocking some of the structural funds each country is entitled to. Such a move would clearly have negative implications for fiscal positions at a time when both countries can ill afford it. In a worst-case scenario, it is possible these nations may look to exit the EU.

And in Turkey, the government has pursued a heterodox economic policy at the behest of its populist president, causing its currency, the lira, to go into freefall in late-2021.

All in all, the shift towards better creditworthiness and strengthened political institutions that aided growth and stability from 2002-12 has gone into reverse. As a result, returns from local fixed income markets have been poor since 2011, even if most of that is due to currency depreciation.

Figure 2: FX losses resulted in a lost decade for EM local bond returns
Past performance is not a guide to future returns
Source: Bloomberg, as of February 18, 2022

Emerging market debt denominated in hard currencies has proved something of an exception. Since countries have tended to borrow locally and refrained from binging on external debt, the prospects for this asset class appear somewhat brighter. However, despite recent widening, spreads over US Treasuries are relatively tight, so even here there appears limited upside. There are still opportunities in the EM sovereign universe given wide variations in creditworthiness and spreads, but picking winners will be more challenging given the macroeconomic and political headwinds.

While sky-high commodity prices could lend some support, emerging market assets look to be heading for further turbulence over the course of this year. We favour being selective and looking for relative-value opportunities, as described in our House View 2022 Outlook.

The outlook could turn more favourable later this year or in 2023

The outlook could turn more favourable later this year or in 2023 as inflation declines and markets begin to anticipate interest rates peaking. Eventually, a less imbalanced China, stable inflation, better economic prospects for EM relative to DM, and the attractive valuations across equities, credit, and currencies will present plentiful investment opportunities.


  1. Source: Bloomberg, as of January 25, 2022
  2. Source: Eikon Datastream, as of January 25, 2022
  3. Source: Eikon Datastream, as of January 25, 2022
  4. Min Zhang and Dominique Patton, ‘China 2021 iron ore imports retreat from record on steel curbs’, Reuters, January 14, 2022

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