Emerging markets are countries that are in the process of developing and have lower levels of per capita income compared to developed countries. Developed markets, on the other hand, are countries that have advanced economies and well-developed financial systems.
As central banks in emerging economies went ahead and started raising interest rates before central banks in developed economies, Alejandro Guin-Po, Economist at LarrainVial Asset Management and Robert Horrocks, PhD CIO, at Matthews Asia give us their views on how this affects markets and whether emerging markets may represent a more attractive alternative.
What is your view on the state of emerging versus developed economies?
Alejandro Guin-Po: We are now returning to a reality in which emerging economies are once again growing at a higher average rate than developed economies, a historical relationship that had been broken in the years following the pandemic. At the same time, inflationary pressures continue to be strong in much of the world, but – apart from conditions inherent to each country – we see that they are diminishing due to the reduction in maritime tariffs, transportation costs, and normalization in supply chains, as well as lower demand pressures as a consequence of a slowing economy.
Robert Horrocks: The state of emerging markets today seems to me to be far more susceptible to fear than to greed. I could point to many advantages of emerging markets, but probably many more advantages that Western markets have enjoyed over the past decade. I think investors are disappointed with emerging markets, exiting emerging markets, and are much more comfortable with their home markets. This is particularly the case in the U.S. In Europe, perhaps less so, as they look forward to the coming likely steep recession with concern. The tensions between China and the U.S. loom large over emerging markets, as does the possibility that the world is dividing into two spheres of influence. In that sense, perhaps we will stop using the terms developed and emerging and start using different terms? The U.S. is already phrasing things as autocracy vs. democracy, but one could easily say producers vs. consumers, or collective vs. individualist, or savers vs. spenders. Perhaps that argues for a change in the way we view portfolios, too?
What is the fact that emerging economies have started to raise interest rates before developed economies?
Alejandro Guin-Po: The fact that emerging economies have started to raise their monetary policy rates earlier than developed economies has definitely helped their inflationary convergence and especially their expectations, highlighting the fact that central banks in emerging countries were usually “followers” of their peers in developed countries. The most notable case is Brazil, which was one of the first countries to start an aggressive rate hike cycle almost two years ago and today maintains inflation expectations almost at the upper limit of its central bank’s mandate. In contrast, other issuers such as the Fed and the ECB have tacitly acknowledged as a mistake having delayed their normalization and have pushed through powerful rate hikes in response to inflation levels that had not been reached in the last four decades and to which we were not accustomed.
Robert Horrocks: One of the things about this cycle is exactly as you have pointed out—emerging economies did not wait for the U.S. FED to start hiking and then reluctantly follow. Emerging markets have been far more resilient and confident about managing their own monetary policy. Obviously, the dollar still tends to strengthen at times like this. But, by and large, we have not seen and currency crisis. One or two currencies (I am thinking principally of Turkey) are being kept afloat by a kind of petrodollar diplomacy from Saudi Arabia and Russia. However, for the most part, emerging markets have toughed it out successfully.
What is your opinion of the situation regarding the public debt of emerging versus developed economies?
Alejandro Guin-Po: The debt situation responds to a fundamental issue, which is the confidence behind the ability to pay. For example, the United States maintains a debt of around 130% of GDP and still remains one of the safest creditors in the world. In contrast, other countries, with a lower debt level, such as Colombia – with a debt slightly above 60% of GDP – have lost their investment grade. From this perspective, indeed, the tighter global financial conditions have increased concerns about the most indebted countries, especially those that maintain a higher percentage of their leverage in dollars, which is also a very relevant variable. For example, it is not the same for Brazil or Chile, which have a relevant part of their debt in domestic currency, as opposed to several African nations that keep their debt dollarized.
Robert Horrocks: It’s generally lower in emerging markets but that is because people are less willing to hold emerging market debt at times of stress. The key issue with debt, however, is not the level but rather the speed of accumulation of debt and the ability to service interest rates. I think people got concerned when China’s debt increased rapidly. However, it has reduced the pace of debt expansion and current interest rates suggest there are no problems in servicing that public debt. Indeed, China has on the margin become a little more successful in persuading some foreign nations to hold its debt. I suspect it shall become increasingly successful as it continues to reform its capital markets. Ultimately, it will likely dominate emerging market debt indices and perhaps become its own asset class.
Are emerging markets currently more attractive, and is it the right time to enter?
Alejandro Guin-Po: Emerging markets – especially emerging fixed income – have definitely become much more attractive towards the latter part of the year, because of better growth catalysts and because they are expected to offer positive real returns due to the level of rates recently reached. Given that, it is an interesting opportunity to build a position in emerging markets considering the risk involved and that we still have high volatility in the markets. Therefore, the most advisable thing to do is to act prudently, being careful when selecting the desired instruments and taking into consideration the exposure they entail. This last point is the most relevant considering that although expectations of rate hikes by the Federal Reserve have moderated, the cycle has not yet ended.
Robert Horrocks: They are more cheaply valued. However, the overall quality of company is lower on average than the U.S. If we just look at benchmark performance, that can be disappointing. However, it remains a great universe for true active management and stock-picking. Also, I would note that in much of the emerging markets, both economic and policy forces have been working to favor labor over capital. As we look at our own markets, riding high, we have to remember that they are relatively expensive on profits that may be secular highs with slower rates of economic growth. And perhaps some of what we regard as the superior earnings power of Western businesses has been due to the willingness to sacrifice unions and wage growth. Whether that is sustainable or not politically is anyone’s guess, but it does suggest that long-term earnings growth, already restricted by lower economic growth, may be at risk of a secular wage squeeze. In comparison, wages and profits seem to be in much better balance in many emerging economies.