Emerging Markets Insights: China reaches an inflection point

Three things we’re thinking about today:

1. China reaches an inflection point: China’s inflection point began with the easing of access to credit in the property sector in October 2022. The reset in US-China relations at the G20 meeting in Bali between China’s President Xi Jinping and US President Joe Biden in November followed. The final piece of the jigsaw was the dismantling of China’s zero-COVID policies, which started in November and accelerated in December. Changes in selected cities include home quarantine for positive cases, removal of the requirement for polymerase chain reaction (PCR) test results to travel on public transport, and a reduction in daily testing for school children.
2. Peaking US inflation data: The US median Personal Consumption Expenditure Price Index (PCE), a key measure of inflation, is expected to decline from 6.3% in 2022 to 3.5% in 2023.¹ The high base effect is seen driving the decline, along with an easing of supply chain bottlenecks and the negative effect on growth from higher interest rates. While a slowdown is anticipated, there has been uncertainty over the timing of the peak in inflation. Recent data signal the peak may now be behind us, enabling investors to focus on slower inflation in 2023 and a possible change in the US Federal Reserve’s pace of rate hikes.
3. Earnings recovery in 2023: The prospect for a recovery in earnings growth in 2023 is likely to act as a catalyst for markets, as the slowdown in 2022 earnings has been a concern. In emerging markets (EMs), earnings growth is also forecast to recover; China is likely to be a leader with 15% estimated growth.² A pickup in earnings revisions in EMs would act as a confirmation of better times ahead for earnings and, in turn, equity markets.

Earnings outlook

The divergent outlook for net corporate margins may have an impact on the relative performance of emerging and developed markets in 2023, benefiting the former. Tighter US financial conditions and the potential for US dollar weakness may reinforce this divergence, in our view. Net margins in EMs peaked in mid-2021 at 11.6%³ and have trended down since then, averaging 10.3% in November 2022. Margins tend to be higher than the EM average in the Middle East and North Africa region, buoyed by very profitable energy companies. In Asia, they tend to be lower than the EM average, particularly in South Korea and China. Over the past 20 years, EM net margins have averaged 10.8%.⁴ In developed markets (DMs), net margins peaked in 2021 at 12.0% and have remained elevated since then, averaging 11.4% in November 2022.⁵ US net margins tend to be higher than average, and Europe is not far behind, but Japanese corporate net margins can be as low as half the DM average. Over the past 20 years, DM net margins have averaged 9.0%, almost two percentage points below the EM average over the same period.⁶

Looking ahead, the future evolution of margin trends has implications for earnings growth in EMs and DMs. If the International Monetary Fund’s (IMF’s) forecasts for resilient EM economic growth in 2023⁷ prove to be correct, this should have a positive effect on revenue trends. If commodity prices are also lower relative to 2022, we could see an improvement in margins. This, in turn, could result in upward revisions to consensus earnings expectations, which are for growth of 1% in 2023.⁸ (Weakness in South Korea, Taiwan and Brazil are having a negative impact.) In contrast to EMs, margins in DMs are significantly above their long-term average. However, the risk of a US recession in 2023 resulting in a weakening of pricing power, combined with the existing tightening of financial conditions, signals downside risk to margins. Current consensus earnings expectations are for earnings growth of 5% in 2023, led by the United States.⁹ Upside surprises in EM margins and, in turn, corporate earnings, at a time of the opposite trend in DMs, are a potential driver of EM outperformance in 2023. If the US dollar trade-weighted index continues to weaken from the peak reached in September 2022, we believe this should provide a tailwind to EM fund flows, and in turn, markets.

WHAT ARE THE RISKS?

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1. Source: Bloomberg, December 2, 2022. There is no assurance that any estimate, forecast or projection will be realized.

2. Source: Bloomberg, November 30, 2022. There is no assurance that any estimate, forecast or projection will be realized.

3. Ibid.

4. Ibid.

5. Ibid.

6. Ibid.

7.  Source: IMF World Economic Outlook, October 2022. There is no assurance that any estimate, forecast or projection will be realized.

8.  Bloomberg, November 30, 2022. There is no assurance that any estimate, forecast or projection will be realized.

9.  Bloomberg, December 2, 2022. There is no assurance that any estimate, forecast or projection will be realized.