A Constructive 2022 In Sight

Companies with structural growth drivers aligned with digitization, decarbonization, and other transformative trends will emerge as long-term winners.

The central theses:

There are several reasons to be constructive about emerging markets (EMs) as we head into 2022.

Stock valuations seem to have priced in a lot of caution and suggest attractive long-term value. China's market valuations appear to be near a floor and should be well supported from here in 2021 after significant negative news. While short-term headwinds from regulatory uncertainty and its “zero-COVID-19” stance may continue into 2022, policymakers stand ready to stabilize economic growth if necessary. Positive structural forces remain visible across emerging markets and should encourage new investment opportunities. Digitization and decarbonization are key issues to watch. Financial and current account balances are also in better shape than before, potentially precluding a repeat of the severe market tensions that have hit emerging markets in previous downcycles.

Measured optimism:

2021 has been a challenging year for emerging markets. Mixed vaccination progress across countries contributed to false starts in exiting the pandemic. Economic reopening in emerging markets and the reopening of trading operations in their equity markets subsequently lagged those in developed markets (DMs). China was a key concern - tighter fiscal and monetary policies, the "Common Prosperity" campaign pushing regulatory changes across industries, and a zero-COVID-19 approach combined to keep investor sentiment cool. Concerns about US inflation and the direction of US monetary policy also came to the fore. Major emerging economies such as Brazil, Mexico, Russia and South Korea preceded the DMs by raising interest rates to stem price pressures. Still, there are several reasons to be constructive about emerging markets as we head into 2022. For a start, stock valuations seem to have priced in a lot of caution and suggest attractive long-term value. The fixed income perspective is also encouraging - real yields in emerging markets are exceeding those in DMs. In this regard, we note a shared optimism about EMs with our fixed income peers. Financial and checking accounts in emerging markets are also in better shape than before. Institutional reforms in the major emerging economies over the past few decades have strengthened their economic discipline and resilience to crises. Strong commodity prices have been an additional windfall for commodity exporters of late. More stable EM finances may rule out a repeat of the severe market tensions that hit EMs in previous down cycles.

Various EM drivers:

China's market valuations appear to be near a bottom and should be well supported from here after significant negative news for 2021. Granted, some short-term headwinds could stretch into 2022. We expect China to maintain its zero-COVID-19 stance well into the year to ensure the success of the Winter Olympics and the 20th National Congress of the Chinese Communist Party. International travel and other mobility restrictions will limit economic activity. Regulatory uncertainty could also persist. We believe the recent regulatory changes are in part a function of China's political cycle, which is likely to culminate in the 20th National Congress. Eventually, as the policy dust settles, regulatory clarity should return, as it has in previous policy cycles. On a positive note, China's authorities have shown that they still have a strong pro-growth agenda and have no intention of suffocating the private sector with rules. They have the policy tools in place to stabilize growth and are ready to use them when needed, as we saw with the country's recent reserve ratio cut. In Brazil, valuations have fallen to extremely low levels, creating interesting investment opportunities. Concerns over potential fiscal easing, rising interest rates and the likelihood of a left-wing resurgence in next year's general election have led to a sell-off in markets. Even then, Brazil's fundamentals appear to us to be healthier than they have been since the last recession. More recently, its fiscal and current account balances have improved, with higher oil prices benefiting the net oil exporter. The macroeconomic tailwind has also had an impact at the company level. For example, rationalization and rising cash flows, helped by rising oil prices, have enabled state-owned oil producer Petrobras to significantly reduce its debt in recent years. India's economic activity has recovered since its second wave of COVID-19. The credit cycle has shown signs of picking up and big banks have seen healthy loan growth. The housing cycle has also picked up as a result of better home affordability, along with a recovery in the infrastructure cycle amid the government's infrastructure push. A robust financial and current account picture has accompanied India's cyclical acceleration.

Worldly Possibilities:

Positive structural forces remain visible across emerging markets and should encourage new investment opportunities. Digitization is a central topic. India's thriving internet economy has attracted capital looking for new areas of growth, particularly given China's regulatory shift. E-payment, grocery delivery and other disruptive business models have taken hold, prompting even traditional businesses to use innovation to counter the competition. In China, industrial digitization has gained momentum as the economy keeps an eye on progress in the value chain. Globally, the ongoing semiconductor shortages underscore the huge demand for chips resulting from technological advances, and we expect strong earnings for some of the world's largest semiconductor companies in markets like Taiwan and South Korea. Decarbonization is another trend to watch. Pledges by major emerging economies to achieve carbon neutrality are likely to intensify electrification and renewable energy efforts, creating multi-year support for relevant industries. We've seen the growth of South Korean EV battery manufacturers and Chinese solar energy companies accelerate sharply, propelling them into world-leading industry positions.

Resilience in the midst of risk

Certain risks, although not included in our base case, could change our overall EM outlook. For example, a sharp and sudden rise in US interest rates could trigger market volatility. Conversely, dovish US policy could help EM outperform DMs. Meanwhile, more dangerous variants of COVID-19 could emerge amid the ongoing pandemic. Market volatility following the recent discovery of the Omicron variant is a reminder of the remaining uncertainties, although indicators so far suggest that the variant's symptoms may be milder than feared. We are also monitoring China-Taiwan relations as cross-strait tensions rise. As the investment environment evolves, a key characteristic we seek to see in emerging markets is resilience, both in terms of their economies and their companies. What is particularly important to us is the sustainability of corporate earnings, whether in the face of COVID-19, political changes, technological disruptions or other challenges. We see companies with structural growth drivers aligned with digitization, decarbonization and other transformative trends to emerge as long-term winners, which should support EM stocks going forward.

(The author of this article is Manraj Sekhon, CIO at Franklin Templeton Emerging Markets Equity. The views expressed are his own.)

(Edited by: Dipti Sharma)

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