LDEM - Emerging Markets Insights: Emerging Market Banks Are Resilient

2023-04-07 11:11:00 ET

Summary

• The liquidity crisis impacting selected developed market banks has unnerved emerging market investors.
• Markets have recovered from the turmoil following the liquidity crisis impacting some banks in the United States and Europe.
• Emerging Asian stocks finished the quarter higher, with gains in the technology-heavy countries of Taiwan and South Korea providing a boost.

Banks in emerging markets are more resilient than US and European banks that suffered a liquidity crisis, according to Franklin Templeton’s Emerging Markets Equity team. Find out why:

Three things we are thinking about today:

1. Implications of liquidity crisis in selected developed market ((DM)) banks. The liquidity crisis impacting selected developed market banks has unnerved emerging market ((EM)) investors. In our view, the risk of contagion to EM banks appears low given higher capital levels and tighter regulation. Implications that we are thinking about today include the impact of lower US bond yields and rising risk aversion among providers of capital. Lower US bond yields could result in a weaker US dollar, which is good news for liquidity in EMs. However, rising risk aversion among banks and alternative providers of capital could reduce the availability of credit. In the coming months, investors need to monitor both factors to gauge the impact of the liquidity crisis in selected DM banks on EMs.
2. Reorganization among Chinese technology companies. With its provisions on the storage and transfer of data, the Chinese data security law, which came into force in 2021, affected technology companies. The impact of the law was initially negative, but managers of these companies and investors have since become comfortable with the law, which is similar in its provisions to the US CLOUD Act. ¹ The implications of the law partly drove China’s largest technology company to recently announce a corporate reorganization, which the market received positively. Other Chinese technology companies could announce similar reorganizations to unlock value, resulting in more focused companies and investment opportunities.
3. Impact of US Inflation Reduction Act (IRA) on EM. To benefit from the IRA, a country needs a free trade ((FTA)) or similar agreement with the United States. A quarter of the 20 countries that have an FTA are EMs, including Mexico, Chile and South Korea. Operating in a country without an FTA implies companies exporting to the United States cannot benefit from the subsidies offered for renewable energy or the electrification of transportation. This is particularly relevant for EMs supplying raw materials for batteries. Indonesia is the world’s largest supplier of nickel, a critical input to the production of batteries. The country is receiving increasing foreign direct investment on hopes of an agreement similar to that of Japan who recently signed with the US on critical materials for batteries. Commodity producers’ recent and planned initial public offerings are deepening Indonesian capital markets and raising the country’s profile among EM investors.

Outlook

Markets have recovered from the turmoil following the liquidity crisis impacting some banks in the United States and Europe. Looking ahead, uncertainty toward emerging market ((EM)) banks also looks to be contained. EM regulators took swift action, which highlighted the robustness of their banking systems and limited exposure to affected banks. In our view, banks in EMs are more resilient and have a lower risk of deposit flight due to higher capital levels and tighter regulation.

The tight regulation of EM banks is reflected in the high levels of excess capital they carry on their balance sheets. Banks in China, India and Brazil carry between 3-6 percentage points of capital above local Tier 1 capital requirements and hold more capital than the minimum required under Basel III regulations. Furthermore, our thorough due diligence process when it comes to investing emphasizes resilience and sustainability of corporate earnings. As such, in our portfolios, we favor leading local banks with strong business models that stand to benefit from growing penetration of financial products in their respective markets.

We continue to examine how the companies we invest in navigate these near-term issues. We also continue to focus on longer-term structural trends including digitalization, urbanization and consumerization, which we believe are likely to be the source of attractive investment opportunities. Besides strong bank names, we also favor technology enablers such as semiconductors, IT services, battery and renewable energy-related companies. We believe these companies are benefiting from disruption, digitalization and new energy trends.

While investment sentiment has recovered since the start of the banking crisis, we remain watchful of developments that could change our overall outlook, especially those that could spill over to EMs. Our on-the-ground teams benefit from timely and ongoing insights from company management, business leaders and channel checks. This active engagement ultimately relates to a high-conviction, well-diversified portfolio with low directional bias, focused on the longer term.

Emerging markets key trends and developments

Both emerging and developed market equities rose in the first quarter of 2023. The period began with a strong start in January. March was volatile, with mid-month weakness tied to the liquidity crisis hitting select DM banks, followed by a month-end recovery. Falling US dollar bond yields supported gains among technology companies in both EMs and DMs.

For the quarter, the MSCI Emerging Markets Index advanced 4.0%, while the MSCI World Index rose 7.9%, both in US dollars. ²

The most important moves in EMs in the first quarter of 2023

Emerging Asian stocks finished the quarter higher, with gains in the technology-heavy countries of Taiwan and South Korea providing a boost. China’s equity market also ended the quarter higher—its reopening, regulatory clarity, and a focus on stimulating domestic demand spurred investor sentiment. Indian stocks were pressured on concerns of a consumption slowdown and potential contagion risks from the liquidity crisis impacting selected developed market banks.

EMs in Latin America also rose. Inflation was a key theme in most countries, with Brazil and Peru revising economic growth for 2023 downwards. The impact of higher interest rates on consumption could drag down growth in Brazil, while weakness in Peru was largely due to domestic unrest. Mexico was the top performer in the sub-region, with the central bank official providing assurance that monetary tightening is reaching an end.

EMs in the Europe, Middle East and Africa region declined as a whole. The central banks of Qatar, Saudi Arabia and the United Arab Emirates raised interest rates, but a recovery in oil prices benefited Saudi Arabian equities. Electricity shortages and rising costs of living impacted South Africa, while Turkey grappled with earthquakes that prompted a selloff in Turkish equities, resulting in a momentary halt in trading.

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.

1. Source: Skadden, Arps, Slate, Meagher & Flom LLP.

2. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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