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.

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