UBS: Why Emerging Markets Should Romp—and It’s Not All China

Emerging markets have had a tough time and only recently have begun to, well, emerge again. Part of that owes to the reopening of China from its COVID-19 lockdown, as China makes up one-third of the MSCI Emerging Markets Index.

But China’s turnaround is not the only reason for the improvement in EMs’ fortunes, according to a UBS research paper. Abating inflation, the Federal Reserve’s slowing rate hikes, a weakening dollar and tech stocks’ impediments are other important elements, the bank’s report stated.

The EM index this year, through Monday, is up 6.7%, not far behind the S&P 500, the standard U.S. gauge, at 7.1%. That implies a rebound from a long stretch of underperformance for emerging-market shares. Among expected winners for 2023 are India, South Korea and Mexico.

For many years before 2022 (when everything fared poorly), American stocks were doing far better, riding a wave of tech mania that less-developed nations did not possess. In 2021, U.S. names clocked 26.9%, compared with negative 2.5% for EMs. Over the past 10 years, ending in December 2022, the S&P skunked the MSCI EM, 12.6% to 1.5%.

China has come thundering back this year, to be sure, with the Shanghai Composite increasing 4.1% year to date. Over the past 12 months, thanks to the lockdown, it was in the red, 5.4%. Now, however, the Chinese reopening is producing a “positive spillover effect into other emerging markets,” UBS observed. China’s stocks should outpace the rest of the world, thus further propelling EMs, the bank predicted.

Regardless of how China’s stocks do, EM stocks’ outperformance “has further to run,” UBS reckons. One strong influence is the peaking of U.S. inflation and a weaker dollar. The Consumer Price Index dropped to 5.7% in December 2022, down from a high of 6.6% in September. (The CPI report for January is due February 14.) As a result, the Federal Reserve is expected to slow its tightening campaign.

“This downshift speaks in favor of fading Fed hawkishness over the course of the year … [and] is supportive of emerging market assets,” UBS commented. “The U.S. dollar has started to depreciate, and longer-term interest rates have started to decline, thus helping to loosen financial conditions in many emerging economies.” Indeed, the dollar has dropped 8% from its September 2022 peak.

The EM nations often depend on dollar-denominated borrowing costs, and some even have their currencies pegged to the greenback.

Meanwhile, U.S. tech is coming back, but not strong enough to provide the pizzazz that fueled the American stock rally through 2021—good news for EM stocks, as the entire world is no longer passing them by to bet on the U.S. The tech-heavy Nasdaq Composite has a long way to go to make up lost ground: It has shed 14.9% over the last 12 months, down twice as much as the S&P 500 for the same period.

The UBS projection is that EM stocks will “deliver mid- to high-single-digit positive returns this year.”