With apologies to iconic rock fans, the song remains the same for emerging markets investors. Emerging markets once again underperformed domestic and international developed equities during the third quarter. Through the first nine months of the year, the MSCI Emerging Markets Index has fallen 27.2%, versus declines of 23.9% and 25.1% for the S&P 500® Index and MSCI World Index, respectively. However, intrepid emerging markets investors are hoping for better times in 2023. What’s the likelihood?

The problem 
What’s been the chief culprit for the sour notes? In a word—inflation—which has carry-over effects shaping monetary policies globally and, by extension, currency performance. All that has spelled trouble for global investors and emerging markets in particular. 

A hawkish U.S. Federal Reserve focused on inflation containment has implemented aggressive rate hikes—likely intended to be larger during the beginning of this rate-hike cycle. Incidentally, the U.S. dollar has surged to its highest level since 2002, up 7.1% in the third quarter and up 17.2% for the first three quarters of the year. Although this demonstrates the enduring power of the world’s reserve currency, these gains put pressure on regional currencies, proving a challenging environment for other global central banks given the current geopolitical climate. As an example, for the first time since 1985 the pound sterling (GBP) teetered near parity with the U.S. dollar, reflecting both elevated inflation and the dysfunctional British political climate. Likewise, a stronger U.S. dollar has helped push the Euro to fresh 20-year lows.

The outlook
Looking forward, inflation and the Fed tightening cycle remain among the most pressing concerns for global markets. Recent U.S. inflation figures exceeded consensus expectations both at the headline and the core level. Global central banks continue to demonstrate resolve in their inflation fight and are apparently willing to sacrifice economic growth in the process. It’s important to remember, however, that we are in one of the most aggressive tightening episodes in history, with 85% of the global central banks in tightening mode. Still, we believe the Fed’s overarching focus on price stability raises the risk of policy error. With inflation yet to have peaked and the Fed raising interest rates in 75-basis-point increments, the end of September marked this current bear market in emerging market equities as the longest in the history of the asset class. 

While none of this sounds like particularly cheery news, it’s important to remember that the equity market is a discounting mechanism that tends to bottom before the environment actually improves. Plus, the backdrop can and will change, often when least expected. In other words, currencies actually do move in both directions.  

Moreover, if the front-loaded interest rate hikes are successful in bringing the inflation path toward target, it may give central banks room to pause hiking by the end of 2022, and several emerging market central banks might even start cutting rates ahead of the Fed in anticipation of a global slowdown. Perhaps even more surprisingly, our research shows that emerging market equities have actually outperformed U.S. and developed market equities during Fed tightening cycles over the past three decades. That statement bears repeating.

In terms of valuations, we view emerging market equites as attractive at approximately 10.2x 2023 P/E,  according to third quarter estimates by BBG/FactSet, which is at the lower end of the historical range. This represents an approximate 25% discount to global developed market equities, also as of quarter-end. Some markets are well below historical averages, including China, Korea, and Brazil. On the other hand, India remains on the expensive side, at 18.9x 2023 P/E, which is above pre-Covid levels. Again, all this illustrates both the diversification potential of emerging markets, as well as our preference for an active approach with the ability to tilt portfolios where we see greater value and potential. A passive approach that requires allocation across all 24 emerging market nations at all times, even when there are clear causes for concern, never seems to make much sense to us.

No doubt that it has been a historically challenging year for global markets. And while we see a central bank-orchestrated global slowdown on the horizon, there may be a sweet spot in which the U.S. is in a recession mild enough to allow monetary conditions to loosen and alleviate the dollar-induced pressure. This could help change the tune for emerging market investors.