Several forces could begin to change growth dynamics this year. While developed-market (DM) growth slows down, economic growth is set to remain solid in EM, bolstered in part by China’s reopening impulse. Since the 20th Communist Party Congress in October, the government has rapidly reopened the economy and reaffirmed its focus on prioritizing growth. Consumer confidence is poised to recover as COVID restrictions loosen. Meanwhile, record-high savings levels should boost consumer spending.
Taken together, these moves could reenergize China’s GDP growth, providing a lift to both earnings and equity market performance, in our view.
We’re also seeing signals of declining inflation across various EM countries, including India and Brazil. As inflation slows and the US Federal Reserve approaches the end of its tightening cycle, some EM central banks may gain the confidence to pause or reverse their own tightening cycles, which weighed on economic growth over the past two years.
Some EM economies will benefit from supply chain reconfigurations. Many companies are diversifying their supply chains away from China. This is driving manufacturing toward countries from Mexico to India to Indonesia to Vietnam. For instance, Indonesia has seen increased interest from global auto and auto-parts manufacturers drawn to the country’s vast natural resources and ability to supply key inputs for electric vehicles, such as nickel and copper. Vietnam and Mexico benefit from their proximity to China and the US, respectively, and from existing supply chain networks.
On the Margins: Profitability Differential Poised to Converge
Poor earnings growth has weighed on emerging companies over the last decade. The gulf between US and EM profitability has been especially wide since COVID began amid the dominance of US mega-caps and rising prices, which surpassed costs.
While American companies have a good track record of innovating and reinventing themselves, the hurdles to exceptional profitability will probably be higher than in the past. Weaker US economic growth, regulatory pressure on big tech and elevated labor costs could compress US margins—and contribute toward EM companies closing the profitability gap.
Currency Counts for Countries and Companies
Emerging markets are often vulnerable to swings in currency. In recent years, the strong US dollar has created multiple challenges. It made USD-denominated prices less competitive and affected the funding environment for EM countries and companies running external balances.
The US dollar appears to have peaked in September after appreciating for several years. If this trend continues, EM equities could enjoy a currency-fueled boost. That’s because historically, there has been a strong correlation between foreign portfolio flows to EM and the US dollar. If improving growth outside the US helps moderate the trajectory of the US dollar, we would expect a pickup in portfolio flows to EM equities.