Spring, it seems, is not in the air for South African and other emerging markets in the wake of the Jackson Hole central bank meeting at the weekend, with emerging market currencies and stock markets selling off more sharply than their developed counterparts on news that the world’s fight against inflation will continue unabated.

By the time the season’s change came around, the JSE All Share Index had lost close to double the US benchmark S&P 500 Index’s decline, with the former coming off 4.2% and the latter 2.4%. The dollar-rand exchange rate had also depreciated from R16.84 a dollar to R17.14 a dollar in just four days — a 6.2% depreciation year to date and 13.3% on a year ago.

South Africa wasn’t alone in the intensity of the turnaround in risk appetite, with all risk assets, particularly those in emerging markets, adversely affected by the hawkish tone taken by central bankers at the annual meeting — clearly a disappointment to the many who were expecting the Fed to pivot on recent signs that inflation may have peaked.

Since the beginning of the year, emerging markets have come off 19.3%, according to the MSCI Emerging Market Index, compared with an 18.7% decline in the MSCI World Index and 17% fall in the S&P 500 Index’s year to date.

News from Jackson Hole that disappointed included Fed chair Jerome Powell’s comment that the overarching focus will remain on bringing inflation back to the 2% goal and “is likely to require a sustained period of below-trend growth”.

He envisages using the tools to restore price stability “forcefully to bring demand and supply into better balance”.

Positive take

Investec economist Anabel Bishop had a more positive take on the outcome of the central bank meetings, saying it signalled that the US has some potential flexibility in its monetary policy after its hard approach late in the second quarter of this year. She believes higher rate hikes of around 100 basis points are unlikely, while lower 50-basis point ones “are quite possible, which is positive”.

Time will tell whether the response to Powell’s statements — and resultant shift in risk appetite — will prove well founded. In the meantime, however, there are a number of other clouds that make winter weather in emerging markets more likely to hang around than sunny climes.

Latest International Institute of Finance analysis on emerging market portfolio flows finds that there were “exceptionally large” outflows in quarter two — even more than outflows from local currency bonds in the first quarter. In July, non-resident outflows slows but didn’t reverse, and the latest bout of risk aversion could well see outflows continue into September.

China’s outflows were most noteworthy, with the IIF describing the record $81-billion net outflow from stocks and bonds as “remarkable” and potentially signalling a structural change for the worse in the perceived geopolitical risks posed by the country.

The institute’s analysis found that macro variables, including the growth slowdown, Fed tightening and People’s Bank of China’s easing, can explain only 50% of the outflows. It says portfolio investment flow to China is a weathervane for China’s financial health and global investor confidence. 

“We are not saying zero-Covid policies, weak growth, depreciation and falling rate differentials do not matter. Just that there is something more fundamental unfolding due to perceptions of heightened geopolitical risk.”

The potential for European stagflation is also contributing to a worrying outlook, with growing expectations that the European Central Bank may opt for a jumbo 75-basis point interest rate hike in the face of deteriorating economic prospects and its energy crisis.

Patches of sunlight

But there are patches of sunlight in between the clouds for emerging markets that could turn around their fortunes, should economic conditions and thus investor appetite improve.

One plus is that most emerging markets are further ahead in their rate hiking cycles, which could allow central banks in developed economies to ease off the accelerator and give them more scope to buoy their economies.

Lazard Asset Management is positive on the number of attractive investment opportunities that could come available in the coming months because many emerging markets began tightening monetary policy in early 2021, and, as a general rule, local yield curves tend to peak when the terminal rate has been reached. 

The investment manager expects nearly half of the local emerging countries to reach their terminal rates by the end of 2022 — way ahead of the developed world, where terminal rates are only expected to be reached by the end of 2023.

Oxford Economics director of EM strategy, Regis Chatellier, adds that although inflation in the emerging markets continues to rise, “an increasing number of countries have been surprising on the downside, suggesting inflation could start easing soon”. That would give central banks “significant policy room” to support economic growth, he says.

SA equities looking ‘positive’

On the whole, emerging market stock market valuations look compelling — with emerging market equities trading at substantial discounts to their developed market peers. Coronation Fund Managers is particularly positive on SA equities, with investment expert Neville Chester pointing out that the last time domestic equities looked this attractive, was 10 to 15 years ago.

Oxford Economics believes local currency emerging market bonds are attractively valued, but a weaker dollar would need to sustain a rally. It is also positive on emerging market equities based on an ongoing recovery in earnings per share momentum, led by China. 

“Downside risks have risen, but low valuations provide a degree of comfort, particularly for those markets most exposed to the China recovery,” it argues.

The research company sees the SA rand as one of the three emerging market currencies, including the Brazilian real and Colombian peso, that are the most attractive based on their real, effective exchange rates. BM/DM