Emerging Market Insights: Headwinds for EMs from higher bond yields

Three things we are thinking about today

1. Rising bond yields and a stronger US dollar. After falling to a low of 3.4% in early February, US 10-year Treasury bond yields have risen sharply over the past month as investor expectations of the terminal value for US interest rates moved higher.¹ This led to an increase in the US dollar trade-weighted index by 3% over the same period. Dollar strength also weighed on sentiment toward emerging market equities, which have an inverse relationship with the level of the greenback. Higher US bond yields and interest-rate expectations have a negative impact on long duration assets, including technology companies. These companies, which have a high weighting in Asian emerging market indexes, tend to see downward pressure on their share prices as interest rates rise.
2. Renewed focus on governance. Selected companies in India and Hong Kong which are perceived to have below-average corporate governance have come under attack from so called “short sellers.” Aggressive accounting practices related to debt and depreciation policies are among the factors that short sellers highlight in justification of their negative views on these companies. We believe that investing in companies with good corporate governance, which includes factors such as conservative accounting practices, engagement with all stakeholders, and timely publication of annual accounts is the best way to avoid exposure to companies that are at risk from a short-selling attack. We also acknowledge that the perfect company rarely exists.
3. Slowdown in electric vehicles (EV) sales. Chinese EV and hybrid vehicle sales declined 6.3% in January.² Chinese manufacturers have started to cut EV prices as sales soften, and in preparation for new product launches in the coming months. Balancing this negative factor is the weakness in lithium prices, a key input material for EV batteries, which have declined almost 30% from November 2022. Lithium prices have declined on weaker-than-expected demand and rising supply. Lower lithium prices is good news for EV manufacturers, where batteries can account for 45% of the manufacturing cost.³

Outlook

The macroeconomic newsflow in the coming months may continue to cause market swings. Nevertheless, we remain focused on how the companies we invest in navigate these near-term uncertainties, as well as longer-term structural trends including digitalization and premiumization. Our investment team is focused on these trends in emerging markets (EMs), which we believe are likely to be the source of continued investment opportunities.

Over the last 10 years, we have witnessed increased EM investment opportunities due to stronger institutions, diversified growth drivers, and technological advancements. Electric vehicles (EVs), solar panels and semiconductors are a few examples. Currently, we see some of the existing trends accelerating, along with increased consumer spending power, which we believe will continue to be recurring sources of growth over the long term.

In the coming months, we believe the roll out of pro-growth policies in EMs could be a significant tailwind to domestic demand in selected markets. Across continents, local governments have introduced measures to cushion the impact of inflation and/or to spur consumption, and in turn, economic growth. In Latin America, Brazil will extend social welfare payments while Mexico and Colombia will raise the minimum wage, alongside Hungary and Poland in Europe. Some Asian governments are implementing tax cuts—the Philippines will extend lower tariff rates on eligible food items and Thailand will extend an excise tax cut on diesel. India will likely continue to prioritize capital expenditure to improve infrastructure, and has plans to venture into green tourism, where up to 50 new tourism destinations will be opened.

We believe that these policies, coupled with the presence of companies with exposure to new technologies that will drive future sustainable economic growth, present opportunities for the EM investor. EMs are home to both upstream and downstream firms in key technologies for the future including EVs, solar panels and semiconductors. Our focused investment approach enables our on-the-ground teams to identify business models and management teams that display agility and resilience in a fast-changing world.

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. The value of investments can go down as well as up, and investors may not get back the full amount invested. Stock prices fluctuate, sometimes rapidly and dramatically, due to factors affecting individual companies, particular industries or sectors, or general market conditions. Special risks are associated with investing in foreign securities, including risks associated with political and economic developments, trading practices, availability of information, limited markets and currency exchange rate fluctuations and policies; investments in emerging markets involve heightened risks related to the same factors. Investments in fast-growing industries like the technology and health care sectors (which have historically been volatile) could result in increased price fluctuation, especially over the short term, due to the rapid pace of product change and development and changes in government regulation of companies emphasizing scientific or technological advancement or regulatory approval for new drugs and medical instruments. China may be subject to considerable degrees of economic, political and social instability. Investments in securities of Chinese issuers involve risks that are specific to China, including certain legal, regulatory, political and economic risks.

IMPORTANT LEGAL INFORMATION

This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice. This material may not be reproduced, distributed or published without prior written permission from Franklin Templeton.

The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The underlying assumptions and these views are subject to change based on market and other conditions and may differ from other portfolio managers or of the firm as a whole. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. There is no assurance that any prediction, projection or forecast on the economy, stock market, bond market or the economic trends of the markets will be realized. The value of investments and the income from them can go down as well as up and you may not get back the full amount that you invested. Past performance is not necessarily indicative nor a guarantee of future performance. All investments involve risks, including possible loss of principal.

Any research and analysis contained in this material has been procured by Franklin Templeton for its own purposes and may be acted upon in that connection and, as such, is provided to you incidentally. Data from third party sources may have been used in the preparation of this material and Franklin Templeton (“FT”) has not independently verified, validated or audited such data. Although information has been obtained from sources that Franklin Templeton believes to be reliable, no guarantee can be given as to its accuracy and such information may be incomplete or condensed and may be subject to change at any time without notice. The mention of any individual securities should neither constitute nor be construed as a recommendation to purchase, hold or sell any securities, and the information provided regarding such individual securities (if any) is not a sufficient basis upon which to make an investment decision. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments, opinions and analyses in the material is at the sole discretion of the user.

Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.

Issued in the U.S. by Franklin Distributors, LLC, One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com – Franklin Distributors, LLC, member FINRA/SIPC, is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.

_________________

1. Source: Bloomberg.

2. Source: Fastmarkets, “China auto output, sales plunge in January after end to buyer subsidies exacerbates weak demand.” February 16, 2023.

3. Source: McKinsey.