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Rob James

Market Outlook

Emerging Markets (Unconstrained) Outlook

Outlook
10 January 2024

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Emerging Markets Portfolio Manager

Latest Emerging Markets (Unconstrained) economic and market outlook. 

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With real rates in much of EM at anomalously high levels and inflation falling in many countries across Latam and Asia, we continue to be positioned for EM central banks to lead the upcoming easing cycle. From an individual market perspective, LatAm is our key overweight, most notably Brazil, Mexico and Argentina. 

Real rates in Brazil remain extremely elevated. With Fed rate hikes likely to be finished, this should refocus the market’s attention on Brazil’s capacity to cut. The central bank has started the process, but we expect another 300-400bps in cuts over the next year or so. Importantly, we believe that the Brazilian currency will be resilient in the face of such cuts, partly because it is extremely undervalued on a Real Effective Exchange Rate basis, and the carry remains high. The currency should also be supported by a positive inflection in Brazil’s trade balance. Export volumes of agricultural commodities and oil have been growing rapidly over the past 10-15 years, and such volume growth is now being combined with a strong pricing environment. This terms-of-trade improvement means that Brazil’s trade balance is currently running at almost $10 billion per month. On an annualised basis this equates to nearly 6% of GDP – close to twice the level of previous peaks. Over time this could transform Brazil’s current account, potentially leading to structurally lower interest rates. Whilst our primary motivation for overweight exposure in Brazil is a cyclical rebound from heavily depressed valuations as the cost of capital normalises, we also believe that this structural element is underappreciated by the market. We therefore continue to own companies that should benefit from a normalisation in the cost of capital, particularly in the mid-cap space, where many rate-sensitive companies appear to offer compelling deep-value opportunities. However, in recent weeks we have been using strength to take some profits in Brazil and have generally been looking to improve the quality of the portfolio there. It is a similar story in Mexico, where we have been locking in some profits, but retain exposure to beneficiaries of nearshoring-related investments, most notably selected banks. 

The decision to elect radical libertarian Javier Milei changes Argentina’s political and economic landscape significantly. Milei has proposed to substantially reduce state interventionism and chronic fiscal deficits. Given the scale of the challenges, Milei’s inexperience, and the limited amount of political capital available to spend, successfully implementing his macro-orthodox adjustment plan comes with a high degree of execution risk. Whilst we are in ‘wait-and-see’ mode with regard to the broader Argentinian economy, we continue to have high conviction in the potential of its oil and gas sector. Regardless of who is leading the country, hydrocarbons are seen by all parties as Argentina’s main get out of jail card. The country is home to Vaca Muerta, the world’s largest shale oil and gas deposit outside the US. Developing this world-class asset should result in record oil production for Argentina over the next decade. In 2022 the Oil & Gas sector (direct and indirect) accounted for 11% of GDP, which is anticipated to rise to 19% by 2030. Meanwhile, the country’s energy balance of trade is expected to inflect from a $5bn deficit in 2022 to a $20-25bn surplus by 2030. This should enable the country to move to a current account surplus, which is key for economic stability. Politicians across the spectrum understand this, and unsurprisingly the sector was already being supported under the previous administration. Such support may even increase under Milei’s free-market-leaning presidency as he has stated that he aims to deregulate domestic energy prices and let them converge with export parity, while privatising oil producer YPF. 

In Asia we continue to be constructive on India as we expect a turn in the investment cycle, continued government investment, and increased investment from multinationals to capture India’s domestic market and diversify their manufacturing bases away from China. However, our Indian exposure is tempered by valuations, which remain rich in many sectors.  

Elsewhere we see an extremely attractive structural growth opportunity in both logic and memory semiconductors, driven by rapidly increasingly demand from a range of new applications, most notably High-Performance Computing and AI. Digitalisation had already been accelerating for some time, but this has now been turbocharged by AI. At the same time, we are emerging from a cyclical trough, where semiconductor inventories have been run down substantially. We believe this powerful combination of structural and cyclical drivers as well as attractive valuations should result in a period of outsized returns for shareholders. We therefore own a number of semiconductor/memory plays in Taiwan and Korea.

Finally, China remains our key underweight. We believe that the country’s high-savings, high-investment model has reached its limit, and for sustainable future growth, the economy must become far more consumption-driven. This ultimately means that demand must now catch up with supply. However, this is no mean feat as the country faces multiple drags on consumption, including a youth unemployment rate of 20%, a falling working-age population, negative wealth effects from a weaker housing market, and a lacklustre post-covid reopening.

Important Information:

Nothing in this document constitutes or should be treated as investment advice or an offer to buy or sell any security or other investment. TT is authorised and regulated in the United Kingdom by the Financial Conduct Authority (FCA).

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