The Worst is Likely Behind for Emerging Markets

Despite a confluence of unprecedented shocks, emerging markets (EM) have shown resilience, with few signs of a broad-based crisis. As an asset class, EM appears to be positioned for stronger performance.

High EM real – or inflation-adjusted – rates buffer the spillover risks from further U.S. Federal Reserve (Fed) interest rate hikes and the effects of the strong U.S. dollar. China’s economic reopening provides a tailwind, and the peaks in inflation and fiscal pressures appear to have passed.

Structural forces such as deepening local markets and nearshoring support EM fundamentals. The magnitude of last year’s EM fund outflows suggests the asset class is now both structurally and cyclically under-owned, while EM valuations screen as historically cheap, in our view.

As a result, we are becoming increasingly positive on EM more broadly and select EM local debt in particular. Still, we remain cautious until the outlook for monetary policy becomes clearer, as much depends on the Fed’s ability to tame inflation and China’s ability to reactivate economic activity.

EM is resilient to the downside, and central banks have done their jobs

Pretty much everything that could go wrong for EM did in 2022, with pandemic pressures exacerbated by the war in Ukraine, the Fed rapidly hiking rates, high energy and food prices, China’s zero-COVID policy, the rise of populist regimes, and idiosyncratic climate problems.

Yet the majority of EM countries have recovered to pre-pandemic GDP levels. Leverage in EM has remained in check, with debt broadly stable relative to GDP (see Figure 1).

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That resiliency is likely to continue in 2023. EM benefitted from proactive central banks that – unlike in previous episodes – prioritized controlling inflation over growth and did so earlier than developed market (DM) peers, raising real rates well above neutral levels.