In this episode of Markets in Focus

Global storms are brewing, and a key question for investors is whether a global recession is inevitable. Antonina Tarassiouk, Fixed Income Analyst at Reams Asset Management, and David Vaughn, Chief Investment Officer for Non-U.S. and Global Strategies at ClariVest Asset Management, discuss possible opportunities in emerging markets that may be poised for growth, despite recession fears.

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Transcript

Matt Orton:
Global storms are definitely brewing and one of the key questions for investors right now is whether a global recession is inevitable as many of us now assume, either because the economy gives into price pressures or because central banks are forced to generate one to combat inflation. A secondary question is how this will impact different regions of the world. So much of the market narrative has been focused on the U.S. and Europe, and perhaps developed markets more broadly, but I often find myself asking, "What about emerging markets?"

Many emerging market central banks have been ahead of the curve in raising rates, and those rates may be at or near cycle peaks already. Perhaps recession isn't a foregone conclusion across many EM (Emerging Markets) economies, and trade and fiscal policies could be supportive for growth. There's also been a tremendous divergence between performance across EM equity markets, bonds and currencies, which means there might be significant opportunity for investors. So how should investors look at approaching such diverse investment space and what are some of the biggest challenges and opportunities?

This is Markets in Focus from Raymond James Investment Management. I'm your host, Matt Orton, and I invite you to join me and my colleagues as we discuss the latest trends driving the markets. Visit us at marketsinfocuspodcast.com for additional episodes and insights.

Here to help break down the opportunity set across emerging markets, I have David Vaughn, chief investment officer for non-U.S. and global strategies at ClariVest Asset Management, as well as Antonina Tarassiouk, fixed income analyst at Reams Asset Management. Thank you so much for joining today.

Antonina Tarassiouk:
Great to be here.

David Vaughn:
Great to be here.

Matt Orton:
Great. Let's start very broadly because I think there's some additional context that's going to be helpful for our discussion. David, maybe you can start by contextualizing emerging market performance over the past few years, which broadly has been pretty disappointing relative to the U.S. Why do you think EM equities have been underperforming and how has this impacted valuations relative to developed market equities?

David Vaughn:
There's no question emerging market returns have lagged U.S. returns. The Morgan Stanley Capital International, or MSCI, emerging market index has lagged the U.S. index by over 20% since the end of the third quarter of 2020. Obviously, we can blame some of the emerging market, or EM, under performance on the Russian stocks in the index. If you compute the return to the index with Russia excluded, it's around two and a half percent higher. Of course, Russia is no longer a part of the benchmark, but looking closer, two key points jump out.

First, China was a huge drag on the benchmark. It was down more than 30% over this period. If you compute the return to EM with China excluded, then you'll find that the rest of the benchmark lag the U.S. by less than 5%. Second, the strength of the dollar has been a tough headwind for the EM index when measured in dollar terms. Most EM currencies, other than the Mexican peso and Brazilian real, fell against a dollar over the last two years.

Matt Orton:
Okay, that's great context. Let's bring in Antonina here to follow up on the dollar strength. Antonina, why has the dollar been so much stronger than EM currencies and are there any nuances here that are worth pointing out?

Antonina Tarassiouk:
U.S. dollar strength has definitely been the theme this year. The strength in the dollar itself, though, was not a surprise, given that we were heading into a year where the Fed was supposed to start raising rates. The surprise really came from how long it has lasted and the extent of it. The basket of currencies against the dollar DXY is up 18% this year. Besides, the more hawkish Fed, what has really added to the extent of dollar strength are two things.

One, the negative shock in terms of trade in Europe, given higher prices in natural gas, and two, the slowdown in China because of the continued lockdowns and weakening property sector.

Matt Orton:
Great. I like that you're both breaking things down into twos. Very, very clear for all of our listeners. David, let's just round out the question then. I want to let you respond to the final part of my previous question, which is about EM valuations. How do they look right now, particularly relative to developed markets?

David Vaughn:
With regard to valuation, it's no secret that multiples have contracted sharply over the last two years for both developed and emerging markets. To a large extent, we can pin this on rising global interest rates. Emerging markets now have a forward price-equity ratio of around 11 versus 15 for MSCI World, despite their strong growth potential. Thus, I believe there is a modest amount of relative value there for EM.

This value has a good chance to get unlocked if global interest rates continue to rise, although of course it all depends on how things play out.

Matt Orton:
Thanks David. It's interesting to see what a difference there is in valuation where you pointed out 11 on EM versus 15 for MSCI World. That's pretty significant. Now that we've set some background, let's touch on something that I know is in all of our minds, which is inflation. David, looking forward, how do you think inflationary pressures will impact emerging markets broadly, and are there perhaps some regional winners and losers as a result?

David Vaughn:
Higher inflation has a very negative impact on EM households because lower income levels mean elevated food and energy prices have a disproportionately larger effect, which can lead to much suffering and unrest and of course less consumption. That said, countries that are heavy commodity exporters such as Brazil and Indonesia are naturally helped by rising commodity prices, so this acts as an offset.

Matt Orton:
Antonina, let's build on this theme a little bit. Country profiles clearly matter when it comes to feeling the pressures of inflation, as David pointed out. I would say there's a record-wide divergence in emerging market inflation cycles in terms of trade, which suggests larger differentiation within the asset class. Where have you been finding opportunity this year and how is this changing central bank policy across emerging markets continues to evolve?

Antonina Tarassiouk:
You're right, EM differs significantly across regions. If we take inflation, for example, Latin America, or LATAM (Latin America), has experienced double-digit inflation. Brazil has had inflation over 12%. Asia, on the other hand, has been more contained. China is under 3%. In terms of trade, we see divergence as well. LATAM, mostly commodity exporters, has benefited from higher commodity prices this year. However, Asia, where they're mainly commodity importers, has suffered.

As a consequence, central banks have reacted differently. LATAM has been raising rates aggressively. Brazil started their raising rates last March, well ahead of the Fed, from 2% to now 13 and three-quarters, where they have now paused. Asia, on the other hand, has been lagging in their tightening cycle as they're focusing more on the slowdown in the economy in general. This is reflected in their assets. In LATAM, Brazil is still up year to date, above 6%, while in Asia, for example, if we take Korea, which is highly dependent on China, is down almost 15% this year.

Matt Orton:
How do you see that evolving? I know you said, Antonina, that Brazil is likely done But do you see central banks still holding off in Asia, or do you think that might change?

Antonina Tarassiouk:
I think the central banks in Asia are definitely catching up. If we focus specifically on the EM world, a lot of those economies are highly dependent, like Korea or Taiwan, on China so it will depend on when we see the recovery there. I think China plans to reopen in the first half of 2023, and that will boost domestic consumption and help the economies close to them, including the ones that depend on China as well.

They're going to lag the developed markets, which is already hiking rates aggressively and they're definitely lagging LATAM, but they're there.

Matt Orton:
Great. Thanks Antonina. Let's think about the effect of the U.S. tightening cycle as well. David, maybe you can talk about what effect that the U.S. tightening cycle might have on emerging market equities.

David Vaughn:
A key concern that comes up when U.S. rates start to rise is to what extent might they cause capital outflows from emerging markets. An example of this is what we saw with the taper tantrum of the so-called Fragile Five countries in 2013. The Fragile Five countries are Brazil, India, Indonesia, South Africa, and Turkey. In general, countries that have large current account deficits require foreign capital inflows to finance those deficits.

Back in 2013, yields rose sharply in the U.S. as the Fed signaled an earlier than anticipated exit to quantitative easing. As a result, the Fragile Five countries fell sharply as investors anticipated that higher U.S. rates would divert foreign capital from those markets. However, today's situation is somewhat different. These countries now have much lower current account deficits.

In fact, four out of five of the Fragile Five markets have outperformed the U.S. over the last two years. India is a big star in this group. It has become the second largest country in the MSCI index by weight surpassing Taiwan and Korea. It has recently had the fastest economic growth in the world and has overtaken the UK to become the fifth largest economy in the world.

Matt Orton:
Let's talk about India a little bit more. It's fascinating when we talked about divergences earlier between EMs. India has really, really stood out. It's been such an outperformer within the EM complex this year. Antonina, maybe you can share any thoughts on perhaps why India has been such a standout and has the rupee performed in line with expectations or has it been a tailwind or a headwind for its economy?

Antonina Tarassiouk:
Absolutely. India has been very interesting to us for two reasons. One, it is actually not as tied to China growth as one would think. Their exports are three times more to the U.S. than China.

Two, if we look at their currency in specific, it has been the best risk-adjusted carry, which is the rate differential to the realized volatility of all currencies, better than LATAM even like Mexico or Brazil. This has built a strong case for India.

Matt Orton:
Antonina, I'm also curious to get your thoughts on what I'd say is a pretty daunting task in front of EM policymakers to ensure that inflation comes down and how that impacts investment opportunities. Some central banks have been aggressive rate hikers, as you talked about Brazil earlier. What has been working and what hasn't and how have you looked to position around that?

Antonina Tarassiouk:
Yes, when we decide on positioning, we really rely on our framework. Two things here. One, the valuation of the currency is extremely important and it's hard to do, so we use models like real exchange rate or purchasing power parity. But the thing with currencies is that they can stay over- or under-valued for long periods of time, so we have to look at market fundamentals and we have to use tactical tools like equity momentum, for example.

Relying on this framework, our biggest thematic international position this year has been in Latin America, in specific Brazil, Colombia, and Mexico. Primary drivers in this sector, we’ve already talked about some, but I'll go over them.

First, as I said, valuation is very important. All these currencies came historically cheap into this year. The reason behind it was the pandemic and the lagging in recovery from these economies.

Second, you already talked about it, is the credible central banks, they were determined to fight inflation. I mentioned earlier, and you did as well about Brazil. Brazil started hiking in March 2021 and went from 2% to 13 and three-quarters where they are now.

Third, is we can't go and talk about LATAM without mentioning the high carry they have. Brazil is the highest carry, but on vol-adjusted (volatility-adjusted) basis Mexican peso actually holds the best vol-adjusted carry.

Fourth is the improving terms of trade. Obviously, the higher commodity prices have benefited all the exporters, which most of Latin American countries are. We saw really strong performance during the first quarter of this year. Brazil appreciated over 17%, Columbia about 8%, Mexico about 3%. Year-to-date, if we don't take into account the Russian Ruble, Brazil is actually the best performing currency this year.

Matt Orton:
Which is very, very interesting considering what's happening around the world. You mentioned exporters, which puts China on my mind. David, I want to make sure we circle back to China since it is such a large part of the emerging market equity universe and it's not a region that you shy away from despite the many challenges. Maybe you can help shed some light on why the Chinese equity market has been struggling so much lately. Is it all just related to the zero COVID policies?

David Vaughn:
China initially recovered faster than the rest of the world from the pandemic in 2020. Unfortunately for them, the vaccines they use have proven less effective than those used in the West. Their strict zero COVID policy has led to a number of restrictions in lockdowns and has hurt their growth substantially. Furthermore, some of their companies, particularly in the tech sector, have faced very heavy regulatory headwinds.

While there are some signs that these pressures are letting up, China is now facing a property crisis and home prices there have fallen for the last 12 months. Home buyers with incomplete properties that they're paying mortgages for have started to protest, and in some cases, have refused to pay their mortgages. This has led to fears that bad debt levels are rising in China.

At the end of the day, though, China has shown time and time again that they have both the skill and resolve to work through the economic challenges that they face. A permanent bet against the Chinese equity market is probably a big mistake. As an example of this, one of the largest property developers recently restarted almost all of their halted projects, presumably with help from the government.

Matt Orton:
Perfect. Thanks for the color. I want to transition a little bit as well and talk about the U.S. dollar because it has been front and center this year with a lot of increased volatility. It certainly had implications on emerging markets. Antonina, what are your thoughts on the dollar going forward and do you expect the next big trade is further dollar strength or do you see potential weakness?

Antonina Tarassiouk:
I think that is the question of the year. For the dollar to peak, we have to see really three things here. One, inflation in the U.S. needs to peak. Two, is China's economy slowdown needs to bottom out? And three, European natural gas market needs to stabilize. I think we're close for the inflation to peaking in the U.S., however, I think we're further away from China bottoming out and European natural gas market to stabilizing.

As I mentioned before, the reopening of China is expected at the beginning of next year, so we have some time to hold for their domestic demand to really pick up. In terms of Europe, on a positive note, the storage levels are at target, which is great. However, heading into winter, there are really just a lot of uncertainty around weather in Europe, which we can't forecast perfectly at this point and then flows in Russia.

Everyone thought that Nord Stream 1 would stay at 20%, and here we are with no flows going forward. I think the next big move will be an adjustment in the dollar, however, we have to wait for it.

Matt Orton:
Perfect. Well, maybe this will be the one winter where we hope some of the global warming trends will benefit the world to help Europe out a little bit and not have a freezing cold winter. We are coming up against the clock, so I want to get both of your thoughts on the top opportunities and the biggest risks in emerging markets equities and currencies heading into the end of the year. David, I'm going to let you start and then I'll give the final word to Antonina.

David Vaughn:
As Yogi Berra said, "It's hard to make predictions especially about the future." But I'll try. I believe the biggest upside scenario is that China works through the COVID lockdown and property crisis issues and goes through a similar economic recovery to what many other countries have had after their lockdowns ended.

This would bolster China as well as its trading partners, help fix supply chain issues, and would likely generate a lot of excitement about emerging market equities as an asset class, given China's huge weight and influence in the index. On the other hand, the biggest risk as I see it, relates to a slowdown in other parts of the world, such as in Europe, due to an energy crisis this winter or in the U.S. because of the aggressive interest rate hikes that are happening.

A material slowdown in growth could cause investors to dump risk assets, such as emerging market stocks, even if the direct effect on emerging market economies was not so large. At that point though, emerging market stocks would likely represent an even better buying opportunity.

Matt Orton:
Antonina, I'll give you the final word.

Antonina Tarassiouk:
Well, we talked a lot about the dollar, and as we wait for U.S. dollar to peak, I think there will be some adjustments going into 2023. There is some criteria that we can look at. First, central bank action. Fed has been crystal clear of what they were going to do. They're going to hike rates, they're going to keep them high for longer and the economy will feel some pain. While we wait for this to happen, the markets are already pricing this in.

If we look for central banks in EM in general, they have been aggressive and hiking ahead of the Fed, like the LATAM central banks and carry opportunities are still there. Then we have terms of trade. I believe that commodity prices will remain high. I know they have adjusted low already, but they remain at high levels. This means that exporters will continue to benefit from this.

I would be cautious with the Eastern European economies in general, given the negative shock in terms of trade and the impact that will have going forward on growth. I would also be cautious with Asian economies and specific those that depend highly on China. As we see, China will bottom out eventually, but I don't think we're there yet.

Matt Orton:
All right. Well, perfect. That's the final word. Well, Antonina, David, thank you both so much for your time and insights today. I really appreciate it. I'm sure our listeners really appreciate it and until next time, take care.

David Vaughn:
Thank you.

Antonina Tarassiouk:
Thank you.

Matt Orton:
Thanks for listening to Markets in Focus from Raymond James Investment Management. You can find additional episodes and market insights at marketsinfocuspodcasts.com. You can also subscribe to our podcast on Apple Podcasts, Spotify, or your favorite podcast app. Until next time, I'm Matt Orton.