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Emerging markets face a trifecta of a global pandemic, the fallout from Russia’s invasion of Ukraine and a sharp rise in global inflation, which also accelerates the global monetary tightening. Sharp swings in commodity prices inform our country allocation, where we prefer commodity-related markets with attractive valuations.
Just as the pandemic is beginning to fade, new risks are beginning to emerge for emerging markets, clouding the outlook. As COVID-19 exits, geopolitical concerns enter, recession risks intensify, inflation rears its ugly head and world central banks embark on a tightening cycle after nearly 15 years of near-zero interest rates. In this context, the underperformance of EM equities versus the MSCI ACWI by 1.6% points in Q1 should be unsurprising.
Russia’s invasion of Ukraine has corollary effects that create headwinds for emerging markets. A surge in the price of grains as well as in energy products, most of which are imported in large quantities by EMs, even if they are exported in raw form, add to inflationary pressures which were already swelling. It also adds to the fiscal burden in countries where a large share of the population lives below the poverty line and where food (e.g. Mexico, Egypt) and energy (e.g. India, Indonesia) prices are subsidised.
Furthermore, emerging markets are set to face export markets which are at increasing risk of recession, whether it be primarily induced by war/supply disruptions such as in Europe or by aggressive monetary tightening such as in the US. Indeed, markets now expect nine further rate hikes in the US (25bps each) and six hikes in both the Eurozone (10bps each) and the UK (25bps each). But while such aggressive tightening may still not be enough to lift rates above the real equilibrium rate (zero or slightly positive), they will most likely lead to some demand destruction as real disposable incomes contract. Taken together, these developments will likely combine to create a period of stagflation and weigh on risk assets.
In addition, the war on Ukraine is likely to accelerate a trend towards decoupling and increased competition between “the West” (democratic, liberal economies) and other more managed and directed political/economic models (e.g. Russia, China). This is part of the reversal of a period of increased globalisation and integration that had begun with the collapse of the Soviet Union and the early market-reforms in China and culminated in China’s accession to the WTO in 2001 and Russia’s in 2012. The economic decoupling will likely also be accompanied by a re-militarisation of the world, foregoing the ‘peace dividend’ that was expected to last as the Cold War ended and the US enjoyed its uni-polar moment. Emerging markets will be collateral damage of this decoupling and intensified competition as they find themselves paying the costs of a war they didn’t launch and of sanctions they didn’t initiate. It is thus no surprise that while the majority of EMs supported the first UN vote condemning Russia’s invasion, many did not embrace the subsequent sanctions or the move to eject Russia from the UN Human Rights Council (notably India). This has been true in particular for countries formerly colonized and/or subsequently part of the Non-Aligned Movement who resent what they regard as one-sided policies.
Against this backdrop, geopolitics are now intricately linked to the macro outlook, all the more so as the recent sanctions against Russia ‘weaponised finance’ through the freezing of official reserve assets. Eventually, this could undermine the dominance of the US dollar and lead to a broader realignment of national interests, although a viable currency alternative currently does not appear in sight.
Market Strategy: The baseline scenario for the global economy outlined in our previous quarterly has been upended thoroughly: instead of a post-pandemic recovery, the world is now facing a menu of sub-trend growth, stagnation and recession. All this in the presence of more elevated and persistent inflation, which will require a determined monetary response. As a result, we realigned our country allocation intra-quarter in favour of countries we expect to benefit from recent commodity price developments and penalizing those that don’t. In particular, this led to an upgrade of Brazil and Malaysia to overweight and, importantly, a downgrade of China to neutral. The latter reflects the refusal of China to join the Western coalition in their sanctions against Russia and the potential for increased tensions with the US. Our other positions were already aligned across commodity lines, for example our underweight allocation to India and our overweight to South Africa.
|Europe, Middle East and Africa|
Note: Up/down arrows indicate a positive/negative change in our asset allocation compared to the previous quarterly outlook. A dash indicates no change.
Source: City of London Investment Management
*The publication reflects asset performance up to 31 March, 2022, and macro events and data releases up to 13 April, 2022, unless indicated otherwise.
The information contained herein is obtained from sources believed by City of London Investment Management Company Limited to be accurate and reliable. No responsibility can be accepted under any circumstances for errors of fact or omission. Any forward looking statements or forecasts are based on assumptions and actual results may vary from any such statements or forecasts.
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