New "friend-shoring" policies could adversely impact shaky EM markets

IMF warns it could reduce global economic activity by 2% and EM GDP by 6%

New "friend-shoring" policies could adversely impact shaky EM markets

While the emerging markets has had a challenging three years, there are still some good markets to watch, despite what may be happening with the new “friend-shoring” policies that are emerging. 

“The trajectory for emerging market countries over the last three years has been more challenged, which also means that the downside risk is a lot lower, whereas we believe developed countries are still earning profit margins above historical ranges and there’s still room for normalization, especially as we head into a potential recession and input prices start to come down,” Christine Tan, assistant vice-president of portfolio management for SLGI Asset Management, told Wealth Professional.

“You’re definitely going to lose pricing power. It just depends on how quickly and how much. So, from a bottom up perspective, the sentiment, earning power, and pricing power of emerging market companies has been less, which means that, even though we’re heading into a slowing economy and the U.S. central bank rate started tightening first, we see room for some central banks in emerging markets, like Brazil, to cut interest rates this year since they’re significantly higher than inflation.

“So, profit margins, earnings levels are quite low coming off of three years of pretty challenging domestic demand. Because of the lack of significant stimulus, you have valuations that are on the upper end of the historical range for emerging market equities. But, if you drill down into specific countries, it’s really only a few countries that are expensive. A lot of the other countries are actually trading at pretty attractive valuations, compared with other regions of the world, where valuations are still quite elevated, with significant downside risk to earnings.”

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Tan noted that, as an asset class, the emerging markets (EM) still look interesting. They started the year-to-date outperforming until the geopolitical risks, particularly around the U.S. and China, picked up and they pulled back. Now, EM is lagging the developed market with more potential risks.


She added that the International Monetary Fund (IMF) has flagged concerns with the new “friend-shoring” policies that are emerging, most notably in recent U.S. administration speeches.

“Friend-shoring” is the act of manufacturing and sourcing from countries that are geopolitical allies. The U.S. Treasury Secretary, Janet Yellen, has been repeatedly calling for it lately.  That’s raising concerns about what that will mean for companies and the markets they usually invest in.

“If you’re a U.S. company that usually builds these hub and spoke distribution centres, it’s not clear exactly what it means. So, there remains a lot of uncertainty, and you my delay your investment unless it’s meant to address the local market,” said Tan.

“For instance, if you’re a consumer goods company – let’s say China is 20% of your revenue – you might continue to invest in China to address the Chinese market. But, whereas, before, you might have expanded that capacity because there’s scale as opposed to building brand new plants elsewhere to expand your capacity to sell to other parts of Asia, now you’re not sure what kind of implications that could have. So, if you’re the CEO or CFO or Board of Directors, the most prudent thing is to say: ‘let’s hold off on any incremental investment that’s meant for expanding capacity other than for the local market’.”

Tan said the IMF warned in its most recent World Economic Outlook that “friend-shoring” could reduce global economic activity (gross domestic product), by 2%. But, smaller emerging countries that are more reliant on trade and foreign money could be hit by up to 6%.

“It’s already started seeing that over the last few months,” said Tan. “It started seeing foreign direct investments between what it calls geopolitically friendly countries go up and those between geopolitically opposed countries go down. In other words, companies and countries re being told to invest not based on what makes sense, like the most efficient supply chain, but more in their friends.

“From one perspective, that does reduce your risk because if one of the core components that you need is with the country that you don’t fully agree with and might one day become your rival, or might one day cut you off, that’s a risk. But, it may actually increase your risk because you suddenly don’t have the diversification. Your friends might also be exposed to the same underlying drivers, so your economies will go up or down at the same time. So, you don’t have that natural diversification.

Tan said it was interesting that the IMF issued that rare rebuke, but she said, “it’s saying, ‘what you’re thinking of doing is going to hurt the world’.”

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While she noted that the U.S. government may be driving this to limit what China can access of its intellectual property or do with its semiconductors, or possibly – as some think – to contain China’s advancement, its making investors much more cautious and could impact the world’s supply chain, particularly as it strives for Net Zero ESG adaptation.

Emerging Market Update

In the emerging markets, Tan said Korea, Taiwan, and India have done well year-to-date as they’ve outperformed the developed and emerging market indices. Much of that is driven by electric vehicle (E.V.) components, particular E.V. batteries and some recovery in semiconductor chip stocks.

India now is an exciting country to watch because two-third of its economy is domestically oriented without the same exposure to global trade as other countries. It imports about 70% of its oil, so has had a good year. It also has the world’s largest population, even larger than China’s, with many well-educated, English speaking young people and many engineers graduating every year.

South Africa has been adjusting since it’s had a lot of issues with unstable power supplies, but the government has offered more licenses to private power producers. So, that should improve by 2024.

She said that Latin America, particularly Brazil, currently has a lot of political noise, but its valuations are very cheap, and it has some amazing businesses to watch.

“So, really, it’s about thinking longer-term, and strategically,” said Tan, “and, most importantly, just finding a way to invest actively through an active manager.”