By Patricia Ribeiro, Senior Portfolio Manager, American Century Investments
Challenges Weigh on Emerging Markets
Hawkish monetary policy, the war in Ukraine and risks from China’s zero-COVID policies have weighed on EM in 2022. But as we enter the second half of the year, we believe emerging markets can rebound.
EM growth factors have been under significant pressure since March 2021. Inflation and subsequent tightening from global central banks have shifted the market narrative away from recovery and growth.
Figure 1 | EM Growth and Value Factors Diverge
EM Factor Performance
Putting the factor rotation of the last 15 months into historical perspective, we can see how extreme the rotation has been in magnitude and duration. This rotation has continued into 2022.
Figure 2 | Historical Data Underscores the Rotation
MSCI EM Growth – MSCI EM Value, Monthly Returns
Style Factor Movement Affects Performance
During the initial post-COVID recovery, equities were positively correlated with inflation expectations, but this correlation has turned negative. Figure 3 shows how the correlation of value factors to momentum is now at levels we haven’t seen over the last 20 years. Meanwhile, the correlation of growth factors to momentum has headed in the opposite direction.
Figure 3 | Momentum’s Correlations with Value and Growth Have Diverged
The Shift Away from Growth May Be Ending
While the latest U.S. inflation data is strong enough to keep the inflation story building, we believe inflation may be peaking. Headline CPI was up 8.3% year-over-year (YoY) in April and 8.6% YoY in May. (Source: FactSet.)
Further, lower two-year yields and a steeper yield curve likely point to a peak in hawkish policy. The growth factor has been very weak over the past year (as shown in Figure 1.) Thus, if we have seen peak aggressiveness by the Fed, we should start to see support for the broader growth equity indices.
All Eyes Are on China
The latest data show new infections retreating, mainly due to the lockdowns. China’s zero-COVID policy and insistence on prolonged lockdowns intended to rid the nation of the omicron variant have weakened its economy. If new outbreaks emerge, they may also bring about a stop/start pattern in economic activity.
Given the high transmission rate of omicron and the low efficacy of vaccines in reducing infections, China will need to continue high-pressure restrictions. Unless it is willing to attempt herd immunity or introduce more effective vaccines, lockdowns may persist.
Hence, China is faced with choosing between a strict zero-COVID policy and the spread of omicron. The former constrains economic activity, while the latter could overwhelm the health care system.