The acceleration of innovation in emerging markets provides reasons for confidence in emerging markets long term, according to our Franklin Templeton Emerging Markets Equity team.
Three things we’re thinking about today
- Latin America: Markets in Latin America have been the best performer in emerging markets (EMs) year-to-date, driven by the rise in the energy sector, which has posted double-digit returns. Looking ahead, Luiz Inácio Lula da Silva’s successful run for a third term as president of Brazil, in combination with his party’s lack of control of either House of Congress, imply that there are checks and balances in place to act as a fiscal constraint. Additionally, recent reforms imply the risk of a repeat of past interference in the management of government-controlled companies has diminished. We remain positive on the outlook for equity markets in Brazil and Latin America.
- Earnings: EMs have witnessed a sharp reduction in 2022 consensus earnings forecasts, which have declined from 6% growth in January 2022 to -11% at the end of October. China has been the primary drag on earnings over this period, but resilient earnings growth in Brazil, Mexico and Indonesia has been a partial offset. Focusing on 2023, EM earnings growth is forecast to witness a modest rebound to 3%, based on consensus forecasts; however, a large portion of this is reliant on the recovery in Chinese earnings, which is far from assured.1
- Interest rates: The size of interest rate increases globally is starting to slow, with the Bank of Canada2 opting for a 50 basis points3 increase in October over its previous strategy of 75 basis point increases at prior meetings. Other central banks may follow this move in the coming months amidst signs that earlier rate increases are starting to filter through to the economy and as the pace of energy price increases starts to slow. This should have positive implications for future inflation and signals we are closer to the end than the start of the rate tightening cycle. While rates are expected to nevertheless continue rising, markets are a discounting mechanism and may start to focus on the timing of the peak in the rate tightening cycle given the increasing risks of a recession in 2023.
In its latest World Economic Outlook, the International Monetary Fund (IMF) cut its forecast for global gross domestic product (GDP) in 2023 to 2.7% from 3.2% previously.4 EM GDP growth in 2023 was also cut to 3.7%, although China is an outlier with GDP forecast to accelerate in 2023 following the COVID-19-induced slowdown this year.
While weaker growth is a concern, we note that the IMF also cut its 2023 inflation forecast in both developed markets (DM) and EMs, which should bring some relief to investors.
GDP growth of 2.7% in 2023 would represent the slowest pace of annual growth in over 10 years, excluding the COVID-19-related contraction in 2020. Since 1970, there have been five occasions when global GDP increased by less than 2%. In 80% of these cases, there was a global recession: 1975/1982/1991/2009/2020.5 While the IMF 2023 global GDP forecast remains above 2%, the risks of a global recession are rising.
The key question for investors is what the market’s reaction will be if the global economy does dip into a recession in 2023. Since the high in developed market equities in January 2022, the MSCI World Index has declined 18% through the end of October 2022, and since the February 2021 high, the MSCI Emerging Markets Index has declined 34% over the same period.6
While it is tempting to believe a recession would put further significant downward pressure on these indexes, we note that the market is a discounting mechanism which is already reflecting a significant recession risk.
If we focus on the market turning points the recessions of 1982/1991/2009/2020 (no data for 1975), the MSCI World Index posted positive returns during the year of the recession. This is not to say the market did not decline; rather, the decline occurred in the period before the recession was recorded. This reflects the market discounting the economic and earnings uncertainty faster than the economic data.
It is also interesting to note that a surge in oil prices the year prior partially induced the recessions of 1975, 1982 and 1991. While oil prices have been on a declining trend for most of 2022, they did surge prior following the Russian invasion of Ukraine in February of this year.
The investment implication from these data points in history, in combination with recent market performance, is that equity markets have discounted a considerable amount of bad news on the economic and earnings outlook. While we cannot rule out further weakness, a 2023 recession is unlikely to be the catalyst for further significant market weakness, in our view.
Slower earnings growth, rising interest rates and global recession risk have created headwinds for EMs. While the outlook remains uncertain, investor focus on what’s happening at the margin and any marginal improvement in the outlook could be viewed as a positive signal.
Despite these uncertainties, we note that EMs are home to companies with exposure to new technologies driving future sustainable economic growth. From solar and electric vehicle battery producers to semiconductor designers and manufacturers, the acceleration of innovation in EMs is driving our confidence in the asset class. Despite the current challenges, we continue to see opportunities to invest in companies with a technological edge which are investing to drive growth.
What are the risks?
All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. Investments in fast-growing industries like the technology and health care sectors (which have historically been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.
Any companies and/or case studies referenced herein are used solely for illustrative purposes; any investment may or may not be currently held by any portfolio advised by Franklin Templeton. The information provided is not a recommendation or individual investment advice for any particular security, strategy, or investment product and is not an indication of the trading intent of any Franklin Templeton managed portfolio.
1. Source: Factset. There is no assurance that any estimate, forecast or projection will be realized.
2. Source: Bank of Canada, 26, October 2022.
3. A base point is 1/100th of a percentage point.
4. Source: IMF World Economic Outlook, October 2022. There is no assurance that any estimate, forecast or projection will be realized.
5. Source: World Bank Working paper, “9172 Global Recessions.” March 2020.
6. Source: MSCI. The MSCI World Index captures large- and mid-cap representation across 23 developed markets countries. The MSCI Emerging Markets Index captures large- and mid-cap representation across 24 emerging markets countries. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses and sales charges. Past performance is not an indicator or guarantee of future results.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.