After a strong rally alongside developed market equities in 2020, 2021 was a difficult period for emerging markets investors. Last year, the MSCI EM Index trailed it’s developed market counterpart, the MSCI World Index, by nearly 25%– the largest spread between the two indices in nearly a decade. Hampered by a lack of vaccine availability, many emerging economies reopened  in fit and starts, often lagging the pace of restart in developed markets. Implications of inflation, and the overhang of expected monetary tightening, were points of consternation. In China and Brazil, the first and third largest economies in EM, regulatory uncertainty and geopolitical tensions roiled local stock markets. 

Despite these challenges we believe there’s a lot of positive energy stored up in emerging markets right now, and that investors may be overlooking a potential opportunity in 2022.

Valuations are Supportive

On a forward-looking earnings basis, the MSCI EM Index is trading at a 42% discount relative to the S&P 500 Index. This represents a significant increase in the pre-COVID spread between the markets— as U.S. valuations have expanded by 17% over the past two-years while EM valuations have contracted by 3%.

Valuation’s differentials are even more stark on a historical basis. Over the past decade, forward looking valuations for the S&P 500 Index have stretched by nearly 75% while emerging market valuations have expanded less than 25%. As we look forward to a more normal post-pandemic market environment, where elevated levels of economic uncertainty begin to dissipate, the prospect of a valuation re-rate provide opportunity for EM relative performance.  

EM’s Relative Growth Potential is Attractively Priced

While growth expectations in 2022 are above long-term trend for both developed and emerging markets, the IMF forecasts that EM economies will continue to see strong post-COVID growth over the next five years. On the other hand, developed economies are expected to return to sub 2% real growth following 2022. While widening spreads between valuation estimates would seem to support a narrowing of the EM vs. DM growth spread, markets are anticipating an acceleration of the relative growth gap between developed and emerging economies.

Coupling relative valuation estimates with growth forecasts, emerging market equities appear to have priced in a healthy degree of caution and reflect an attractive longer-term relative value.

EM is Ahead of the Curve on Monetary Tightening

Inflationary pressure mounted globally as supply-and-demand mismatches were driven by COVID disruptions and exacerbated by the record amount of government stimulus deployed to avoid a deep global recession. While a cycle of policy rate tightening is expected to begin soon across many developed markets, with the Federal Reserve signaling its first rate hike in March, nearly half of the central banks represented in the MSCI EM Index, including South Korea, Mexico and Brazil, have already began raising rates in an attempt to contain rising prices.

With a head start at combating inflation, and generally less burdened by the aggressive stimulus measure out of developed markets like the U.S. and Europe, EM central banks may be able to turn dovish at an earlier pace than many advanced economies.

EM Laggards may be Poised to Bounce Back in 2022

Brazil saw significant deterioration in its macro outlook during the second half of 2021, as political tensions related to upcoming election, and economic uncertainty driven by COVID stimulus, both accelerated. To manage surging inflation, (which was up 11% YoY) the Brazilian Central Bank has had to raise their target rate to 10,75% (from only 2,75% in March 2021). The increasing likelihood of a more centrist president, coupled with aggressive rate raising aimed at stabilizing the currency and inflation, should be a positive catalyst for 2022.

As a result of these issues, the MSCI Brazil Index is trading at a Forward 12mo P/E of 7X. For context, Brazil was trading at 14X (12mo fwd) entering 2020. While not free of problems, the substantial valuation de-rate seems to be compensating for heightened uncertainty and may presents a strong buying opportunity in 2022 and beyond.

Similar to Brazil, China was major drag on EM performance during the second half of 2021. Regulatory tightening measures, especially on property and technology sectors, caused a lot of heartburn. From an economic perspective, China’s twenty year history of unprecedented growth  should garner the benefit of the doubt from investors. Additionally, we  have seen some positive policy signs recently which should provide an increased level of investor confidence. During December’s Central Economic Work Conference, an annual meeting where the CCP sets 2022’s economic agenda, policymakers stressed the importance of stabilizing growth and the potential for regulatory easing to support the property sector. Despite 2021 headwinds, China is still looking at ~5% GDP growth in 2022 and better-than-expected reflationary efforts out of Beijing could lead to an overshooting of that target.

Prior to 2021, the last yearly period where we saw China underperform EM by a double-digit margin was 2016. There were some similarities in 2016 to what we saw in 2021. Most notably, a lack of clarity around regulatory policy that pushed investors for the doors. As investor uncertainty faded, China led a strong rebound for emerging markets in 2017—posting a return of 54% and outpacing the MSCI World Index by more than 30%. The MSCI EM Index as a whole beat the MSCI World Index by ~15%.

While we are not necessarily calling for a repeat of 2016 in 2022, it’s important to remember that following periods when sentiment towards EM has waned, it’s often be a great entry point for investing in EM equities.

Thornburg is a global investment firm delivering on strategy for institutions, financial professionals and investors worldwide. The privately held firm, founded in 1982, is an active, high-conviction manager of fixed income, equities, multi-asset solutions and sustainable investments. With $49 billion in client assets ($47 billion AUM and $1.9 billion AUA as of December 31, 2021) the firm offers mutual funds, closed-end funds, institutional accounts, separate accounts for high-net-worth investors and UCITS funds for non-U.S. investors. Thornburg’s U.S. headquarters is in Santa Fe, New Mexico with offices in London, Hong Kong and Shanghai. For more information, please visit www.thornburg.com.

For more information, please visit www.thornburg.com