Global Emerging Markets Equity Strategy Commentary
March 31, 2022
Emerging markets were weak in Q1 2022 initially on higher inflation as the Federal Reserve turned more hawkish then in response to the Russian invasion of Ukraine. Markets hit a closing low on 15th March and recovered a little into the quarter end. The EM index fell 6.06% in local currency terms and 6.92% in USD. The best performing sector was financials (+5.64%) with energy the weakest (-20.75%) in large part due to Russian exposure being written off and removed from the benchmark by MSCI.
The extraordinary bravery of the Ukrainian forces matched by a poorly performing Russian military has denied Putin a swift victory and a longer conflict has ensued. NATO leaders have avoided an escalation involving member nations so far. A negotiated peace settlement, however distasteful that process is, will be the solution but Putin will only come to the table seriously when he believes he has enough gains to sell his actions to the Russian people as a victory. Given his autocracy’s complete control of the media that may come sooner than expected.
While the invasion has united Western leaders in condemnation of President Putin’s regime and the world’s liberal democracies have responded with sanctions and military aid to Ukraine, the response in emerging markets has been much more restrained. A number of major EM economies such as China, India, Brazil and South Africa have adopted a “neutral” stance on the conflict. China in particular has been subject to criticism and scrutiny over its failure to condemn the invasion, which occurred less than a month after Presidents Xi and Putin issued a bilateral statement ahead of the Winter Olympics in Beijing, declaring a shared ambition to push back against a Western-led world order. Russia’s attempt to brutally re-establish its Soviet sphere of influence, attracting such a fierce response from the West, is unlikely to be what Xi had in mind.
There are some signs that China did not anticipate the full scope of Russia’s incursion in Ukraine (invasion vs. a special operation in the east), signalled by its shifting messaging and failing to evacuate Chinese citizens early in response to Russian moves leading up to the invasion. While China has made complaints about Western sanctions on Russia, it has largely complied. This reflects the economic reality that ties between China and the US/Europe as well as their allies in Asia are far greater than those with Russia. While Russia is an important source of oil and gas for China, nearly half of over $3 trillion in Chinese exports in 2021 went to the US, Europe and treaty allies in Asia. Only 2% of China exports were to Russia. China’s tech industry also relies heavily on equipment and know-how from the West.
The conflict exacerbates the deterioration in global economic growth expectations, which have been revised down as consumer confidence has fallen and real wages are squeezed by higher inflation. Monetary authorities have been behind the curve and are responding too late, instead probably making policy mistakes tightening policy as the global economy slows sharply.
China does not face the same problems with inflation as other major economies, in part due to it not relying on the same level of fiscal and monetary stimulus as developed nations through the nadir of the pandemic. Consumer confidence is nevertheless weak following several recent Covid-19 outbreaks across China coupled with Beijing’s insistence on pursuing a zero-Covid strategy. Added to this is regulatory overhang from crackdowns in the tech, education and real estate sectors last year which culminated in a sharp sell-off through mid-March. In an attempt to calm markets, Vice Premier Liu He made a series of announcements in March indicating that Beijing will pivot to more regulatory predictability and stability, and engage with Washington on financial disclosure rules for US-listed Chinese companies.
The war in Ukraine has also made clear the importance of energy security and supply chain resilience. Western states are looking to undermine Russia’s position as a major supplier of oil, gas, precious metals and agricultural commodities by sourcing these commodities from other suppliers. While this will drive inflation higher and dent global growth, there are a number of commodity sensitive countries such as Indonesia and Brazil which stand to benefit from rising prices.
Our liquidity indicators continue to give a negative signal for the global economy and risk assets. The rise in inflation is probably peaking but tighter monetary policy implemented belatedly by central banks will continue to suppress real money growth. The negative excess liquidity signal usually coincides with relative underperformance by tech and other cyclical sectors while energy and other defensive sectors outperform. Normally high yield and quality outperform while momentum suffers. Higher bond yields due to stronger commodity prices have prevented the usual outperformance by quality which often trades at valuation premiums. The drag from the stock building cycle should ease the upward pressure on commodities allowing bond yields to fall and quality stocks to reassert their usual pattern of outperformance in slow growth environments.
Transactions over the quarter reduced the underweight in China, added to India and Indonesia, while trimming Taiwan, Korea and Greece. At the sector level we have added to energy moving towards neutral, reduced the underweight to materials and moved overweight financials. IT exposure has been reduced largely through trimming cyclical tech exposure in Korea and Taiwan. The focus has been to add to defensive stocks while reducing cyclical exposure. Security selection was the biggest detractor from relative performance in Q1, particularly in China, with sector selection negative and country selection positive. Negative sector selection was a result of the fund’s overweight in IT and an underweight in materials. Underweights in South Africa and Saudi Arabia, rich in commodities and oil respectively, were a relative drag for the fund.
The Composite fell 10.63% (10.55% Net) versus a 6.97% fall for the benchmark.