Emerging market (EM) equities posted negative returns in Q3, against a backdrop of slowing global growth, heightened inflationary pressure and rising interest rates.
Poland was the weakest index market, with Hungary and Czech Republic also among the biggest decliners, as the Russian war in Ukraine escalated and led to an energy crisis in Europe, which in turn has contributed to accelerating inflation. China also unperformed by a significant margin.
Growth-sensitive north Asian markets, such as South Korea and Taiwan, suffered as the outlook for global trade deteriorated. Colombia also performed poorly as commodity prices fell, while the Philippines and South Africa, where concerns about the power situation weighed on sentiment, also lagged the index.
Turkey was the best performing market. Despite inflation that is over 80%, the central bank cut interest rates twice during the quarter and the economy continues to grow strongly. Brazil, India and Indonesia also posted positive returns which were ahead of the broader index.
Emerging markets delivered negative returns over the quarter, with the Fund underperforming its benchmark. Country allocation was negative while stock selection was positive.
At a country level, the overweight to Brazil which outperformed, as well as the underweight to China, which underperformed, aided relative performance. Brazil performed well as investors took comfort from a narrowing in opinion polls ahead of October’s presidential election, and as growth and inflation improved. Data showed the economy growing strongly in the second quarter while the CPI inflation rate has been easing for two consecutive months. China meanwhile underperformed, undoing gains seen in the second quarter. Geopolitical tensions persist — a slump in the property market weighed on investor sentiment, and the imposition of Covid-related lockdowns in various major cities has had a negative impact on domestic demand. An elevated cash position, held in a falling market, also contributed positively to relative returns.
These effects were mostly offset by underweights to India, Saudi Arabia and Indonesia, all of which outperformed, thus detracting value. India outperformed on the back of strong economic data during the quarter, with the manufacturing purchasing manager’s index (PMI) rising to 58.2 and exports growing 1.6% year-on-year in August. Meanwhile, despite a recent softening in commodity prices, Indonesia and Saudi Arabia benefited from elevated prices during the quarter.
Contributors & Detractors
- Stock selection was positive in Korea (o/w Korea Zinc; the Korean metals company announced investments to achieve carbon neutrality, including renewable energy and lithium-ion battery related businesses)
- Stock selection was positive in Mexico (o/w Banorte; the undervalued financial performed well as acquisition fears appear to have been exaggerated)
- Stock selection was also positive in Taiwan (o/w Accton Technology; server-related demand should be more immune to the consumer weakness that may impact other areas of technology. Second quarter results also beat expectations due to a more favourable product mix)
- Stock selection was positive in the United Arab Emirates (o/w Emaar Properties; the buoyant property market demand continued through the summer months and the company also announced the proposed sale of its stake in online fashion retailer Namshi).
- Selection was negative in China (o/w XPeng and LONGi Green Energy; the initial reception for XPeng's new G9 model has been underwhelming, adding to concerns over increasing competition among China electric vehicle manufacturers; LONGi Green meanwhile saw lower export market share in the first half, adding to concerns over competition as Tongwei moves upstream into the solar module market)
- Stock selection was also negative in Chile (o/w Banco Santander Chile; Chile's largest bank in terms of deposits and loans suffered, as the macroeconomic outlook worsened, with loan growth expected to tail off and rising rates impacting the bank’s returns on equity).
Manager Outlook
- Schroders remains cautious on the near-term market outlook. EM faces tighter global liquidity, a strong U.S. dollar, and a likely slowdown in global trade. High EM inflation is driving central banks to tighten policy. The outlook for commodity countries in EM is now less certain, given slowing global growth. China’s credit impulse has inflected but China’s zero-COVID policy poses ongoing risk to near-term growth.
- A more constructive environment in 2023 is possible. Chinese growth may recover supported by policy easing, a low base, pent-up demand, and a potential pivot away from its zero-COVID policy. Inflation may ease on base effects, slowing global activity and easing supply chain bottlenecks. A stabilization in the U.S. dollar and a peak in U.S. bond yields and Fed expectations would provide relief to EM currencies and bond yields.
- EM equity valuations have improved. Negative earnings per share revisions may prove to be a near-term headwind. Relative valuations for global emerging markets vs U.S. look attractive in historical terms. EM bond yields and FX have adjusted.
- Risks to Schroder’s outlook: Economic rebound in China is weak and disappoints consensus expectations, U.S. dollar is stronger for longer, crude oil prices rebound due to supply issues, COVID policy in China, US-China tensions, new COVID variants, the path of inflation, uncertain outcomes of monetary tightening.
