Q2 2023 CIO Review and Outlook

Interest rate cycles are driving changes in short-term sentiment these days and U.S.-China politics seem to be determining the longer-term mood. In the last quarter it was particularly apparent that neither seem to be working in favor of emerging markets. For many investors, it’s been a signal to sit it out on the sidelines.

Clearly, elevated global interest rates do pose a challenge to the outlook of a growth-orientated asset like emerging markets and geopolitics have weighed heavily on Chinese stocks and on companies in the semiconductor space. Underneath it all, Asia and emerging markets, particularly China, have simply struggled to produce the per-share earnings growth that their economic growth deserved. Meanwhile, markets like the U.S. have been outperforming consistently.

So you could be forgiven for questioning the rationale for staying invested in emerging markets, particularly as China labors in its recovery. Our economic theory and stock-picking patience have certainly been tested recently but we remain convinced of the long-term opportunities of this asset class. Here’s why.

Emerging markets and interest rates

First, let’s take a look at inflation and interest rates. After having obsessed over inflation and its permanence or transience for the past two years I feel confident in saying two things: first, that two-thirds to three-quarters of the inflation spike we endured was transient and due to supply shocks that are now almost entirely behind us. Second, the resulting permanent inflation is probably running at no more than about 3% in the U.S. and is still declining, in part due to interest rate rises that have already been made. So we can probably say with some confidence that interest rates have peaked.

So where does this leave emerging market performance relative to developed markets? Typically it’s not been a favorable environment but only because falling rates are usually associated with cyclical economic weakness. However, I wouldn’t assume this to be the unfolding scenario. If the Fed has indeed pulled off the magic trick of a soft landing, a cycle more tilted to growth may play out—and I don’t see many in the market prepared for that. So that could be a tailwind at large for emerging markets.

Growth after a soft landing

The Fed’s rate moves are, of course, are only half the story for emerging markets. What about their central banks? Here there are two plot lines in motion. In the rate hike camp, Brazil got a better start even than the U.S. and Mexico, too, has brought a lot of credibility to macro management over the past few years. So the speed of the decline in interest rates in the U.S. is likely to be matched or even exceeded in these countries as inflation falls rapidly and at the same time the growth prospects of these economies look intact. The other plot line is in Asia, where inflation has been much less of an issue. Countries like Indonesia and India have done a lot to tame exposure to international rate cycles. As for Japan, I’ve always thought that it needed inflation so it’s not a surprise to see its equity markets doing quite well, particularly as the yen has strengthened.

India, Brazil, and Japan have been among the bright spots in emerging and international markets and there is no reason to suspect that any of them will hit harder times if the U.S. dollar remains weak and Fed rates come down. 

And what about the elephant in the room, China. The world’s second biggest economy has no inflation. If anything inflation is too low. Core inflation, excluding food and energy, is at 0.4% year-on-year. The inflation rate is low partly due to the fact that China is emerging steadily but cautiously from COVID lockdown. It is emerging cautiously as the government doesn’t want to overstimulate the economy in the way that (arguably) some western nations did.  

“I suspect these unusually sharp style cycles are a symptom of the unusually severe and severely unusual inflation and growth cycles we’ve experienced. I think these will dampen down and the inflation cycle will normalize.” CIO Robert Horrocks, PhD

China’s challenges

So China is in quite a different macro space and that brings opportunities and challenges. The trick for China is to get incomes (and with it consumer demand) onto a sustainably rising trend, at least in line with nominal GDP growth. I think China understands this and there has been a renewed focus of late in promoting an environment favorable to private enterprise. The private sector is key for the government as it holds in its hands the fate of the vast majority of urban employment and therefore the fate of the China Communist’s Party’s urban popularity, which took a big hit in the later stages of the pandemic.

China may also have to be more aggressive in its attempts to spur quality growth, from the point of view of a balanced macroeconomic policy and return on investment. Just look at the concrete steps taken in India and Mexico, in particular on macroeconomic policy, and in places like Japan and South Korea, in terms of pressure on companies to improve corporate governance and shareholder returns. China has done better on these kind of things of late but it has achieved neither the fanfare nor the practical success that some of its neighbors have.

The other driver of global market sentiment is geopolitics, of course. As we have been at pains to point out there seems little reason to expect things to improve any time soon. Indeed, further sanctions or trade controls seem to be pushing the U.S. and China into separate blocs with the result that economics and investment returns may become less correlated. As investors in emerging markets, I think we have to accept this truth and position portfolios and devise investment strategies that are more in tune with, and cognizant of, the growing importance of domestic policies.

Good businesses at good prices

Ultimately, investing in global and emerging markets is all down to finding companies. And the sluggishness of China’s economic growth and the skepticism towards it, belies the fact that there are still many good companies to be found. The sheer size of the market and the need for a bottom-up portfolio manager to find a tiny portion of good businesses means that short-term skepticism can often lead to good prices for good businesses. From our point of view, China still offers significant opportunities for the long-term investor. So, despite the better performance and perhaps superior short-term outlook in Japan and India, our regional portfolios will more often than not maintain a balance between the major markets.

In recent times, the bigger macro picture has determined to large degrees the trajectory of many equity markets regardless of the performance of their companies. In the falling rate cycle of the pandemic only growth was rewarded, profitable or otherwise. As rates rose, the environment favored more cyclical businesses. I suspect these unusually sharp style cycles are a symptom of the unusually severe and severely unusual inflation and growth cycles we’ve experienced. I think these will dampen down and the inflation cycle will normalize.

It has been a trial for quality growth stock picking and I expect the next few years will be a little easier. And it is quality growth that is shared across all we do. Yes, some of our portfolios are more exposed to emerging businesses and smaller companies. Some portfolios skew to income or established and predictable growth. But the core remains finding good businesses with sensible management, where we can be comfortable with the valuation we are paying. As strategic emerging market investors, we stand by our method, in both favorable times and trying times. 

Robert Horrocks, PhD
Chief Investment Officer
Matthews Asia