By David Ruff, Portfolio ManagerGlobal equity markets have encountered stormy conditions in early 2022, engendered largely by intensifying inflationary pressures and expectations of more pronounced pivots by the US Federal Reserve and other central bank away from accommodation. Interest rates have risen across the globe with most 10-year bond yields up 20 to 50 basis points in the first three weeks of 2022. (Higher interest rates negatively impact stock prices due to a greater discounting of future earning streams). Further, investors worry inflation-induced wage pressures and ongoing Omicron-disrupted supply chains will push up input costs, decrease margins, and hurt corporate earnings. Other than interest rate-leveraged entities like banks and insurance companies, the selloff has been broad and sharp for US equities with the general market Russell 3000 reflecting a year-to-date loss of 8.64% through January 21st. Foreign developed equity markets have followed, albeit with lesser declines, in both Europe ( 2.34%) and Japan ( 3.29%). Surprisingly, emerging markets have managed to gain 1.03%. There are several reasons for this, some temporal, which given the short measurement period should not be viewed as a significant longer-term trend, but other factors are more secular and sustainable.
Of course, with crude oil up 13% year-to-date, Middle East emerging market exporters like Saudi Arabia (+10.04%) have benefited, but Energy accounts for a relatively small 5.6% of the MSCI Emerging Market Index and only ranks fourth in sector returns (+2.28%) year-to-date 2022. Other than Health Care (-5.82%), Information Technology ( 2.54%) and other higher multiple companies whose higher valuation suffered more in this interest rate climate, most EM sectors are flat to higher. Clearly, there is more to the EM story than crude prices. Moreover, while crude may continue to climb short term with fossil fuel supply lagging demand growth, longer-term there should be a supply response and given the Energy sector weight, we don’t view this as a long-term sustainable factor supporting better relative EM performance.
Historically, higher interest rates have caused EM equities to riot. The higher cost of capital adds to corporate debt burdens, drawing crucial capital out of these markets, and triggering currency weakness. Local central banks have little choice but to raise rates to defend the currency, effectively adding to the tightening of financial conditions. In severe situations of markets overly dependent on foreign funding, this can lead to financial chaos. This script basically played out in a limited way in November and early December when the US Federal Reserve first communicated faster removal of bond buying support. With the notable exception of the China renminbi, EM currencies fell almost universally. Since mid-December, however, EM currencies have rallied, despite the intensification of inflation worries and the interest rate climb. As mentioned in the November commentary “Emerging Markets and ASEAN” past painful experiences induced many emerging markets, notably in the Asia region, to denominate debt in local currency. Also, EM trade balances, a more important long-term factor in most currency valuation models, keep improving. For the energy exporters this may be less sustainable, but for the Asia Pacific region due to the supply-chain reconfiguration we look for this to be a secular trend.
We note Asia Pacific (+0.34%) is defending well year-to-date despite being an energy-importing region and dealing with the fast-spreading Omicron. Although Omicron appears to evade immunity acquired from all the existing vaccines, vaccines appear to help mitigate the severity of the disease and much of Asia has rapidly caught up on the proportion-of-their-populations-fully-vaccinated metric. This includes China, reported at 85%, Singapore at 87%, Vietnam at 70%, and Malaysia at 78%. Notably, just as in developed markets, deaths and hospitalizations in emerging Asia have not increased commensurately with the high number of infections. Tellingly, economic data shows continued gradual improvement in the region. The December PMI improved in both ASEAN and China. Surprisingly, China’s Services PMI improved as well. This occurred despite China’s Zero Covid strategy which for every virus flareup results in mass testing and partial regional shutdowns restraining consumption and services activity. Thus, despite Omicron, the recovery in China and Asia, although slowed, continues just as it does in the US and Europe.
Finally, as the economic giant in the region and increasingly the world, China’s policies should be closely monitored. Last year, policies focused on a common prosperity theme. This entailed crackdowns on technology monopolies, reining in the red-hot housing market, executing provincial debt reforms, and installing new stifling regulations on the education sector to name a few of the actions taken to implement the policy. Although GDP growth for 2021 exceeded 8%, these policies along with Covid and power rationing weighed heavily on the economic growth rate in the latter half. Ergo, small businesses were hit especially hard. Approximately 4.3 million small businesses permanently shut their doors compared to just 1.4 million new openings. This net small business drop is a rarity for China and a key element in Beijing’s U-turn change in priority. Cutting benchmark interest rates for the second consecutive month and trumpeting the urgency for more infrastructure spend, leaders now signal that the economy’s stabilization is job one. Indeed, infrastructure investment emphasis is a logical focus, growing just 0.5% in the first eleven months of 2021, far below the 11.2% industrial investment growth rate. Moreover, contrary to the US and most developed markets, China with its strong currency and relatively low consumer inflation at just 1.5% should not be limited in pursuing expansionary fiscal spend and monetary stimulus.
Early 2022 market performance highlights the importance of allocating away from a single market. Investors should especially consider spreading investments across markets at different stages of monetary and fiscal policy. Asia supplies a key part of this diversification benefit and, given better overall economic growth over the full cycle, we believe there will be many unique equity opportunities providing an attractive return for investors. In our ADR and Global strategies, we include several investments exposed to this Asia fundamental story.
The foregoing content reflects the opinions of Advisors Capital Management, LLC and is subject to change at any time without notice. Content provided herein is for informational purposes only and should not be used or construed as investment advice or a recommendation regarding the purchase or sale of any security. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.