Following five consecutive quarterly declines, emerging market (EM) equities continued their recovery from the fourth quarter of 2022 into the first quarter of 2023. The MSCI EM Index rose by 4.0% in the first quarter, although EM equities still underperformed compared to the MSCI World Index, which gained 7.7% during the same period. Gains in global equities came amid optimism that global inflation and the policy rates of major global central banks were close to peaking. This came against the backdrop of a regional banking crisis in the US that spread briefly to Europe. While the crisis had very limited contagion effects on EM markets, it raised the odds of a US recession which could create a challenging external environment for EM growth.
Central banks acted swiftly to address turmoil in the global banking system, resulting in a retreat of bond yields, with the US 10-year Treasury yield dropping 45 basis points to 3.5% in the quarter. The dovish market re-pricing of the fed funds rate fueled a surge in developed market (DM) growth stocks, outperforming their value counterparts by the largest margin (7.1 percentage points) in over two decades. In contrast, EM growth stocks only slightly outperformed their value counterparts, although Information Technology and Communication Services led sector performance in both EM and DM. Commodities saw mixed results, with recession fears weighing on energy prices and Chinese demand bolstering metal prices.
China’s market climbed as much as 17% for the year in late January, driven by optimism that its departure from Covid-suppression policies would lead to a robust, consumption-led economic recovery. Although subsequent economic data confirmed that a recovery was underway in the first quarter, investor sentiment toward China was dampened by escalating US-China tensions over a spy balloon incident and concerns that China was considering providing weapons to aid Russia in its war against Ukraine. After losing most of its earlier gains in February, the MSCI China Index concluded the quarter with a 4.7% increase. A 0.25% cut in the reserve requirement ratio (RRR) in March provided optimism about China’s credit cycle, while technology stocks soared as companies pursued break-ups to unlock shareholder value. China’s currency also appreciated 1.2% against the US dollar, as confidence in the greenback weakened due to the US banking crisis.
Asia emerged as the top-performing EM region in the quarter, with a 4.8% gain. The region benefited from China’s strong performance and double-digit increases in South Korea and Taiwan, driven by optimism about the global semiconductor cycle’s potential bottom. However, India’s market dropped -6.4%, impacted by allegations of fraud and stock manipulation at Adani Group companies amidst tighter monetary policy and slowing GDP growth.
EM Latin America ranked second in first-quarter performance, propelled by Mexico’s 20.3% surge due to robust earnings reports and optimism about benefiting from nearshoring investments as corporations reduce reliance on China. Brazil, however, dragged the region’s performance down by 3.2% as it introduced a new fiscal rule favoring increased taxation. The EM region of Europe, the Middle East, and Africa (EMEA) underperformed, with a -1.2% loss. While the Czech Republic and Greece saw strong gains, losses in South Africa, Qatar, and the United Arab Emirates offset them. Turkey’s market declined -9.4% as the government removed the interest rate cap on an emergency savings plan to stabilize the lira.
EM sector performance varied widely, with Information Technology and Communication Services outperforming the MSCI EM Index. Utilities underperformed due to country-specific issues in India and Turkey, followed by Health Care, hampered by weak performance in Brazil and China. Materials, Industrials, Consumer Discretionary, and Consumer Staples achieved modest 2% gains, while Energy, Financials, and Real Estate saw slight declines of less than 2%.
EM valuations remain low, with the MSCI EM Index trading at 11.8 times forward earnings, a 20% discount compared to the MSCI World Index of DM stocks at 14.9 times. Despite the recent repricing of Fed rate expectations, China’s reopening occurs amid very low domestic inflation, giving the leading EM nation a favorable business cycle position relative to key EM nations focused on combating inflation. We maintain cautious optimism for EM equities, despite ongoing geopolitical risks and potential headwinds to global equity markets if major DM economies enter a recession.