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Avoid becoming an emerging market Turkey

Emerging markets have had their fair share of disaster stories this year, but there are pockets of relative value on offer, too
December 16, 2021

Emerging markets (EM) had a disappointing year as the prospect of a tightening dollar sent shivers through markets. Unless investors were somehow heavily into the Mongolian Stock Exchange (MSE), which more than doubled during 2021, the majority who sat tight on EM shares saw returns go nowhere this year. The 10 per cent gain achieved between January and Frbruary soon withered away and the reason for this is not hard to find when you consider the impact of US rate expectations and a shaky Chinese equities market. The outlook is further clouded by the possibility that a vaccine-evading coronavirus variant could shake up everyone’s calculations.

The performance of some economies during the pandemic, to take Turkey as an example, has been atrocious, exacerbated in part by the increasingly erratic leadership of Recep Tayyip Erdogan. Investors have fled the Turkish lira – which saw of falls of 19 per cent at one point – and annual inflation is now heading north of 21 per cent. Turkey cut back its interest rates earlier this year as President Erdogan sees a lower valued lira as the only way to break the cycle of short-term foreign money flowing into Turkey when interest rates are high. The results might charitably be described as predictable. Whether the lira recovers next year is dependent on how much the country’s central bank is eventually forced to raise rates. The plus point for emerging market investors is that given Turkey’s status as a relative backwater in the financial system, there is unlikely to be any threat of contagion spreading to other economies in either the region, or in the same EM bracket.

 

The Covid threat to GDP growth

While much of the focus of the pandemic so far has been on how ageing societies in Europe have had to adjust to covid-19. The threat has not gone away either for the younger countries of Asia, Africa and Latin America. Schroders points out that the Covid-effect is going to be less about how these country’s healthcare systems are placed under strain and rather how export rates are likely to slow as the year progresses. “Many of the economies have already recovered to pre-pandemic levels, and this naturally makes it harder to sustain above-trend rates of growth.”

EM economies benefited from flattering comparisons with 2020 and global restocking, both to sustain higher levels of demand and to offset issues around supply chains, which gave export orders a huge temporary boost that many economies will find hard to maintain. In response, Schroders has cut its forecasts for EM gross domestic product (GDP) growth from 6.5 per cent to 4.5 per cent for 2022.

 

What about EM equities?

The outlook for EM equities markets generally in 2022 seems to be fairly downbeat, with valuations not particularly cheap compared with their long-term average. For example, the price/earnings (PE) ratio for the MSCI Emerging Markets Index currently stands at 12.8, just above its 11.6 long-term average, having broken a PE level of 16 earlier in 2021. The caveat here is that this covers a huge number of countries, companies and sectors and may be too broad brush to be draw specific conclusions. But when compared with the sky-high valuations for US shares, EM equities acquit themselves well, particularly when currently attractive differences in exchange rates are taken into account.

Overall, Schroders reckons that, despite some uncertainty over earnings for some companies, there is likely to be a positive impact on equity valuations from potential monetary easing as the inflationary pressures that have built up around rapid re-stocking ease and countries look to boost their immediate growth prospects.

Equity valuations in countries such as Poland and Hungary are still reasonable – for example, the MSCI Poland has a PE ratio of 11, a narrow discount to the broader EM index. Meanwhile Brazil could reach a decisive point next year if action against inflation is successful enough for the country to begin loosening its monetary policy. The discount here is more extreme, with the MSCI Brazil showing a PE of just five for the country’s main index.

All of this of course could be thrown off course by Covid, Russian adventurism in the Ukraine or a greater than expected tightening in US monetary policy triggering a rush for the exits. The great misfortune for emerging markets over the past decade is not that they have become more extreme, or mis-managed, or any of the other epithets that are traditionally attached to them. It is that the global financial system, along with its politics, has become more unstable than at any time in recent memory.

It almost makes you wish for the comforting certainties of the Cold War.