Emerging markets offer 'idiosyncratic opportunities' but be cautious

Capital Group predicts resilient EM and 2.5% growth for U.S. economy and equity earnings

Emerging markets offer 'idiosyncratic opportunities' but be cautious

Jared Franz, Capital Group’s Economist, sees several trends emerging in the U.S. and emerging markets in 2022, but admits the view is murky.

“It’s been quite the beginning of the year,” he told a Canada Life webinar. “My crystal ball already has a lot of mud on it. So, don’t hold me to any of this.”

Looking at the U.S., Franz said now that some of its tailwinds – its fiscal policy, unemployment benefits for those impacted by COVID lockdowns, and apartment vacancy moratoriums – have eased, the situations they addressed are adding to the 2022 headwinds, just as the Federal (Fed) Reserve could soon potentially raise rates. Given what’s happening with policy and Omicron, Capital is expecting slower, but not too slow, growth

“We’re not talking about a recession or anything like that. But we’re going from 5.5% to 2.5% growth. That might sound small, relative to 5.5%, but that’s still a great pace of growth with the U.S. economy. Remember this economy is $22 trillion, so 2.5% is above where you want in terms of growth,” he said. Given that the U.S. is not implementing as many shutdowns and he hopes there won’t be more pandemic waves, he said, “I think we’re set up for a decent runway here.”

Emerging markets, meanwhile, “haven’t had the luxury of shutting down, so they have higher quality herd immunity than some of the developed world and they’ll be able to navigate through the recovery,” he said.

While emerging markets may have more resilient activity heading into 2022 and 2023, Franz said the fact that the central banks will be tightening and reducing liquidity usually is not a great set-up for emerging markets. Still, he said Capital believes that “there’s a lot of idiosyncratic opportunities in emerging markets, but you have to be very careful.” He also noted that these are not the same emerging markets of 10 to 20 years ago as they’re much more savvy and have better institutions. While some countries are still wild cards, their institutions have learned a lot of lessons from the past to navigate this recovery. So,” he said, “we’re looking at everything: every country, every region, every sector, every company, hopefully.”

Franz said the Federal Reserve Board and its Chair, Jerome Powell, now are also saying that 7% inflation is a little high and “shifting pretty quickly”, so the market has priced in. Meanwhile, the recent consumer price index (CPI) showed that prices are rising in many categories, so he said that’s “going to alarm the Fed. I think they’re going to have to raise rates a little faster.” The risk then is that the rates are hiked faster than what the market expects, but that may be necessary to get aggregated demand and inflation down to equilibrate with supply. Franz said could help the Fed drop inflation to 2 to 3% by January 2023, which would build the base for inclusive employment growth and pull more people into the labor market.

As for fixed income and hedging against inflation, Franz said that, given the uncertainties of what could unfold, “you want ballast in your portfolio to calibrate the risk as there’s both an upside and downside of the Feds doing too much or too little. If it does too much, you have a big slowdown in growth. If it does too little, you have a big increase in inflation. So, in terms of allocating, you just want to be aware that those exist and be prepared for them.”

In equity markets, he said the key is earnings growth, which won’t duplicate 2021 “and that’s okay”. He expects 2.5 to 3% in 2022. Even though there could be more volatility because of valuation compression, he felt that still played to investors’ advantage for selecting securities.  Historically, he said Capital has discovered that a Treasury yield of 5% is the cut-off where the environment gets worse, so it’s optimistic as it’s not expecting that.