While developed market stocks have, by and large, enjoyed a strong year to date, emerging markets (EM) investors have been facing an array of obstacles. Despite all the stimulus and the ample liquidity provided by global central banks worldwide, EM stocks—represented by the MSCI EM Index—have declined approximately 1.88% over the first ten months of 2021. 

In the face of this lackluster performance, it’s important to remember that the mere fact these EM equities don’t move in lockstep with the S&P 500 Index is precisely one reason they may merit inclusion in a broadly diversified portfolio. 

Moreover, while EM may be a convenient catch-all term, this universe covers a diverse opportunity set, including the full spectrum of industries, all market capitalizations, and stocks that are both value- and growth-oriented (in terms of investment style). On top of that, EM countries span multiple continents with variable economic outlooks. Some may benefit from a higher inflation regime, others not as much. Investors (or managers) with sound judgment should be able to adeptly identify opportunities across this intriguing and disparate landscape. 

Some straight talk

Toward the end of the third quarter, we witnessed an increase in volatility for risk assets, thanks largely to ongoing Covid-19 concerns, rising downside risks in global economic activity, and lingering supply side cost pressures. Energy prices soared in the last month of the quarter, while most other commodities weakened on global growth concerns.

Perhaps one of the largest headwinds facing investors has been the worsening news flow out of China, which unsurprisingly was also one of the worst performing EM countries during recent months. A rash of Covid-19 outbreaks across several Chinese provinces during the third quarter led to lockdowns, which raised concerns on China’s near-term growth outlook. Increased uncertainty around a large Chinese property developer that could default on billions of dollars of debt weighed on sentiment. And Beijing’s heightened regulatory actions also alarmed investors and further weakened the market. Initially, these new regulations were primarily aimed at balancing the interests of China’s major tech firms (and fintech platforms) with Beijing’s own policy objectives of lowering costs, creating more equitable wages, improving competition, and driving home the central government’s authority. 

Some of the regulations (such as the restriction forcing merchants to choose just one platform) are welcomed. But long-term profitability of leading internet/tech companies may remain under pressure given the greater competition and higher labor costs. At a minimum, it will likely lead to increased volatility until there is more clarity on the extent of the new regulatory environment. 

Finally, to throw salt on the wound, China has been going through widespread power outages, threatening supply chains and jeopardizing economic growth. Short-term power outages have oftentimes been an issue at peak summer and winter periods, even as the government is taking measures to limit the overall impact on the economy. All these things have weighed on risk sentiment for Chinese equities, which make up the largest slice of the EM universe.

Staying the Course

Fortunately, it’s not all dire news, especially for any active EM equities manager who can accurately assess the situation and allocate opportunistically. For example, it may be prudent to tilt an EM strategy toward parts of Latin America—perhaps allocating more to Mexico and away from Brazil, where political concerns, incipient vaccination rates and higher inflation have impacted its near-term outlook. Elsewhere, the robust rebound in energy prices looks encouraging for parts of Europe, Middle East and Africa (EMEA). And in terms of valuations, Turkey may offer some opportunistic buys. 

Even in China, despite the near-term headwinds (as noted above), we see that the transition from an export-driven to consumer economy continues apace. China is projected to run a fiscal surplus in 2021, its first in many years, which also suggests that the government may be able to afford further stimulus if needed. This, in turn, could yield some new initiatives to boost infrastructure, consumption and tourism.

In the short term, we expect a choppy 2022 across much of the EM universe thanks to higher deficits, rising interest rates and inflation. However, on the positive side, we believe that the cyclical and industrial sectors will enjoy an extension of the bounce back from the trough of 2021. A rising-rate environment also bodes well for the financial sector. And, as long-term investors, there’s some comfort knowing that we have managed through far worse environments than the current backdrop, and thus we continue to see opportunities to capture growth across the EM universe.