For most of the past 15 years, market analysts have said emerging markets should outperform the U.S. and other developed markets. However, a series of shocks, the latest being the outbreak of Covid-19 and Russia’s invasion of Ukraine, has instilled these markets with new volatility and uncertainty. Has the investment case for these countries held up?

It’s complicated. The short answer is yes and no.

Five dominant trends are acting on this space, and they offer both headwinds and tailwinds.

“Our view is that outside of the U.S., equities are likely to outperform on an annualized basis and possibly by a reasonably wide margin,” says Andrew Patterson, a senior economist in Vanguard’s Investment Strategy Group. “However, the premium for holding emerging markets relative to ex-U.S. developed markets is shrinking, based in part [on] the rising volatility.”

Inflation And Monetary Policy
The Fed and other developed market central banks have embarked on monetary tightening, but because many emerging market central banks have already tightened, they may not experience the significant shocks caused by monetary policy divergence.

“Tightening usually strengthens the dollar,” says Aneeka Gupta, head of macroeconomic research for WisdomTree. But things are different when debt rises against GDP, she adds. “While the dollar appears strong today, that is because it stands out as a safe haven among geopolitical risk. At some point, the U.S. has to contend with its ever-larger debt, and you will see the long-term trajectory of the dollar weaken.”

Many emerging markets have modernized their banking practices and cleaned up their balance sheets, Gupta says, which gives their central banks more credibility to act when their economies slow or overheat.

China, on the other hand, has recently signaled that it may engage in a campaign of monetary stimulus through lower interest rates or asset purchases. This would help counter the impact of its zero-Covid policies, which recently shut down much of its economy.

According to Patterson, Vanguard’s Asia-Pacific chief economist “says that China follows a fight-and-retreat approach, where they go in and support the economy, and then step back and liberalize the economy and financial markets when they are able to.”

“Combined with rising rates in the U.S. and developed markets, I would expect increased volatility … as emerging market central banks react to conditions,” Patterson adds.

Inflation’s impact will be uneven across emerging markets. It will offer a rising tide for markets that are net exporters of commodities—like the Gulf states, Brazil and Indonesia. But it will sandbag those net importers of commodities, like India, Korea and China.

Geopolitical Risk
Inflation headlines were eclipsed by Russia’s February invasion of Ukraine. The conflict is also bad financial news for emerging markets, though Patterson says it’s worth noting that drawdowns caused by geopolitical conflict have in the past been short-lived.

“If you look over time, events like this don’t tend to have lasting implications for financial markets,” he says. “What might be a point of concern for Latin America and other emerging markets moving forward is the long-term structural change to geopolitical relations. The developed markets’ relationships with Russia, China and the U.S. may not look the same, and that may weigh on things like growth and productivity.”

However, investors need to be wary of the downstream effects of the invasion and the potential medium-term effects on food and energy prices. Those impacts will be similar to those of inflation: Net importers of food and oil will hurt, while net exporters could simultaneously thrive.

“Latin American markets have had a strong start to 2022, and a large reason for that is that most of Latin America is a very large commodity exporter,” Gupta says. “As the MSCI Emerging Markets Index declined strongly in the first quarter of 2022, Latin American equities performed very well.”

China, on the other hand, is being squeezed by oil prices.

Global Growth Trends
Global growth is slowing, but the slowdown is uneven. Some areas will continue to grow faster than others, with China being the elephant in the room. China’s growth, which had already been decelerating, has now been frozen by its zero-Covid policies, including the lockdown of many cities.

“We’re coming off a period of high regulation in China, and then you have the zero-Covid policies in effect,” says David Semple, a portfolio manager with Van Eck. “Consumer sentiment there was relatively weak anyway, and we haven’t seen the policies have an impact. There’s a lot of work to be done in terms of engendering a better environment for consumer activities.”

Elsewhere, the growth picture is more positive. India, though it’s an importer of fuel, continues to expand its economy as its middle class flourishes. Since the country is a net exporter of wheat, its economy may show some resilience against global inflation, says Semple, but he adds that India is also usually overvalued as an investment.

In addition to a headwind for many types of investments, inflation is also a symptom of growth, Patterson says.

“Inflationary environments don’t always mean the same thing in different regions,” he says. “Where growth is rising, inflation also tends to increase as a result of demand rising, and that’s a positive for emerging markets.”

Even in China, over time, growth should rebound as the country emerges from lockdowns and feels the positive effects of monetary stimulus. Overall, growth within emerging markets should be stronger than that of developed markets, but it doesn’t necessarily make them the best place to allocate assets.

Valuations
Valuations have been a major factor for those expecting emerging market outperformance in the past, and that remains the case today, even in fixed income.

“We’re roughly trading at medium-term averages in terms of credit spreads, and as we talk it is getting wider and steepening—so at the moment there are pockets of value in emerging markets,” says Ed al-Hussainy, a senior analyst with Columbia Threadneedle. “A lot of institutional-grade, high-quality emerging market debt has really cheapened this year, but the same is true in developed market credit.”

In equities, there may be even better opportunity in some developed markets outside the U.S. Valuations in these markets took a particularly hard hit after Russia invaded Ukraine.

“There have been times where emerging markets have been cheaper,” says Semple. “When you look at their price-to-book versus developed markets and their forward multiple, we’re talking about 15-plus-year lows for the entire developed market asset class. Still, the cash-flow return on equity for emerging markets remains above that of developed markets.”

Factor Performance And Indexing
Besides their attractive valuations, emerging market securities could also benefit from their value tilt. Global investment markets have tilted sharply to favor value since the initial drawdown caused by the onset of Covid-19 in the West.

“In emerging markets, we’ve seen value outperforming growth for a considerable period of time, but it’s clearly been the opposite in developed markets, where until recently growth has outperformed value,” says Gupta. Because emerging markets are naturally weighted toward value sectors like commodities and financials, any global movement to favor value also favors emerging markets.

But emerging markets and global value indexes may not be the best places to capture this performance. The returns tend to be very different depending on the country and region.

After all, the category includes mature and modern markets like Taiwan and South Korea, heavyweights like China and India, distressed markets like Argentina and Zambia, and true frontier markets like Kazakhstan and Egypt.

“As an active manager, I’m biased, but I wouldn’t invest in emerging markets passively, because our indexes are a zoo,” says Hussainy. “No other indexes are this broad in terms of quality.”