Emerging opportunities in emerging markets

Most emerging market (EM) economies struggled in 2021 as slow vaccine deployment and the spread of the Delta variant tempered their recovery. Risks remain, but we see the potential for a rebound—particularly if, as we expect, higher interest rates cause developed-market GDP to revert to a trend.

We think EM economies may be poised for stronger growth in 2022, particularly those at earlier stages of reopening. As DM countries start to withdraw aggressive monetary and fiscal stimulus and EM growth picks up, we expect the growth gap between the two, currently at its narrowest point in at least 20 years, to widen.

An active EM equity strategy may have the potential to outperform a US one over the next decade as EM populations grow and innovation expands. Equity valuations are attractive on a relative basis (Exhibit 12) and earnings growth is running at a decade-high. The region is home to some of the world's best-performing companies (Exhibit 13), though many may not be captured in standard benchmarks, which overweight state-owned enterprises and volatile export-driven industries. An active approach can help investors increase exposure to companies benefitting from secular growth trends.

Treating China separately may help create more efficient EM equity portfolios. China's weight in the MSCI EM Index has doubled over the past five years and could exceed 40% five years from now. An EM ex-China equity strategy offers sector and macroeconomic diversification; for example, EM ex-China names tilt toward semiconductors and tech hardware while China leans toward the consumer retail and internet sectors. This can affect performance; the MSCI EM ex-China Index outperformed the MSCI China Index by 32 percentage points in 2021.

The income potential of EM debt may help to enhance the stability of portfolio returns in a challenging investment environment. EM debt has offered attractive nominal and real yields relative to comparable DM debt. The country selection remains important, as economic and political risks vary. Some assets may struggle if inflation causes the Fed to reduce asset purchases and raise rates more rapidly than expected. But improved EM current account balances mean many EM countries are better prepared to withstand modest capital flight than they were in the past.