Emerging-Market Equities in an Inflationary Environment

From higher commodity prices to increased investment spending to improved trade balances, inflationary conditions are likely to act as a tailwind to EM equities.

Introduction

Inflation. Regardless of whether you think it’s transitory or persistent, what is undebatable is that the combination of expansive monetary and fiscal policy has changed the risks of an inflationary outcome versus the past 15 years.

This increased risk of an inflationary outcome is positive for emerging-market equities, in our view. From higher commodity prices to increased investment spending to improved trade balances, inflationary conditions are likely to act as a tailwind to EM equities.

Why Emerging-Market Equities Now?

There are four main reasons we believe an inflationary outcome is positive for emerging-market (‘EM’) equities.

First, EM equities are a beneficiary of leading inflation. Despite the complete transformation of EM investable universes over the last decade, this inflationary relationship is immediately apparent when looking at the long-run performance of the MSCI EM Index and commodities. Since the inception of the asset class, EM equity has tracked commodities (Figure 1). And as we’ve written previously, industrial commodities have the best real returns through periods of rising inflation.

An expansion in investment spending in developed markets is manna for emerging markets.

An expansion in investment spending in developed markets (‘DM’) is manna for EM. EM economies are largely export-oriented and open. If DM economies are investing, they are typically buying capital equipment and intermediate goods, trade is growing and DM external deficits are expanding. The flipside of that is the EM surpluses expand, benefiting EM equities relative to DM (Figure 3). On a standalone basis, the growth in trade is a support for EM earnings (Figure 4).

EM equities being relatively cheap may prove to be a material advantage if higher inflation does materialise, as inflation is inversely correlated to price/ earnings ratios.

In fact, EM equities being relatively cheap may prove to be a material advantage if higher inflation does materialise, as inflation is inversely correlated to price/earnings (‘PE’) ratios (Figure 6). PE multiples are currently most elevated in the US. With this rise in inflation, would you rather be holding US equities, which are at risk of multiple contractions; or EM equities, which are relatively cheap compared to US and other developed-market equities? We know where we’d rather be…

We acknowledge that there has been a spike in US dispersion during the pandemic, but we believe this is a transient spike, and that dispersion will favour emerging markets once again as it has historically.

Finally, and this is not an argument for now per se, EM equities offers a persistently higher level of dispersion versus other regions (Figures 7-8). We acknowledge that there has been a spike in US dispersion during the pandemic, but we believe this is a transient spike, and that dispersion will favour emerging markets once again as it has historically. Durable alpha ultimately relies on the breadth of independent bets, and the higher dispersion in EM stock returns underpins this rich alpha opportunity. If that is combined with a robust beta opportunity, we believe it’s a highly compelling prospect.

As investors weigh up the likelihood of persistent inflation, one thing at least is clear: history indicates that inflationary outcomes benefit emerging-market equities.

Other Considerations for Investing in EM Equities

While we do believe that the increased risk of an inflationary outcome is positive for emerging-market equities, there are some considerations to bear in mind.

First, the MSCI Emerging Markets Index is becoming increasingly concentrated: not only has China grown as a percentage of the overall market (from 20% in 2015 to 50% now), but more than 30% of the index consists of a handful of names. This has ramifications for the investment processes and portfolio construction. As such, managing portfolio risk relative to the benchmark as it pertains to position sizing as well as industry, sector and country allocation becomes a lot more critical, in our view.

Second, geopolitical issues are always simmering in the background in EM. One needs to look no further than the most recent actions taken by the Chinese government to improve social welfare and its impact on financial markets. News of the Chinese government’s call to restructure tutoring firms as non-profits had far reaching implications, affecting equity prices that extended beyond the USD120 billion private tutoring industry. Turkey is another recent example where a deterioration of economic fundamentals and restriction on foreign capital flows resulted in profound impacts on equity returns. We believe having an increased eye towards risk management is required when investing in emerging markets.