A China ‘spending boom?’ Your guide to emerging market investing in 2023

Published Mon, Dec 26 20227:15 AM ESTUpdated Thu, Dec 29 202210:43 AM EST

2022 was not a kind year for the broader emerging market complex. The iShares MSCI Emerging Markets ETF (EEM) has dropped 22% year to date. That puts the fund on pace for its biggest one-year loss since 2008, when it tumbled 50%. Three key drivers of this underperformance were steep declines in economic activity in China due to the country's zero-Covid policy, a strong dollar and higher interest rates around the world. Looking ahead, strategists and some widely followed investors on Wall Street see a better year ahead for emerging markets, especially as China starts to unwind its strict Covid protocols and the dollar eases off its highs. "We're going to have a spending boom in China, at least in the first half of the year," said Mehran Nakhjavani, emerging market strategist at MRB Partners. "This means that, with a market already exposed heavily to consumer earnings … there's going to be really good support for Chinese stocks," which will boost emerging market equities more broadly. China reopening Earlier this month, the Chinese government implemented sharp changes to its Covid policies, allowing domestic travel and quarantines at home in a move to keep businesses running. Among the changes, people will no longer need a negative Covid test to travel to a different part of the country. Local authorities have also removed many testing requirements. The changes from Beijing came just a few weeks after protests erupted across China over the country's strict Covid controls . Demonstrators clashed with authorities in several major cities, including Shanghai and Beijing, after 10 deaths in a building fire in Urumqi, Xinjiang in late November was blamed on the old quarantine policy. "When you look at the recent events of the past few weeks, it's pretty clear that zero-Covid is out the window. It's over," Nakhjavani said. Now, China will "tolerate very high levels of infection." CNBC Pro's guide to investing in 2023 The Nasdaq had its worst year since 2008. These are the best and worst performers and what to expect in 2023 Oil expected to stay volatile in 2023, but the price could depend on China reopening The crypto investing outlook for 2023 after a 60% decline in bitcoin this year These ETF strategies can help investors navigate a murky 2023 for markets Nakhjavani isn't the only one who sees China reopening as a positive catalyst for emerging markets. JPMorgan chief global markets strategist Marko Kolanovic said in a Dec. 8 note that he sees emerging market stocks returning 14% to investors in 2023 , citing the potential for strong economic growth in China as the country reopens for part of the bounce. The iShares MSCI China ETF (MCHI) has dropped 26% in 2022, on pace for its worst year on record. Meanwhile, the Shanghai Composite is down 15%, headed for its biggest one-year loss since 2018 — when it shed 24.6%. The dollar Another catalyst that could drive gains in emerging markets is a potential decline in the dollar. A weaker dollar tends to boost emerging markets as debt in U.S. dollars becomes easier to service. The U.S. dollar has been on fire in 2022, rising more than 8% against a basket of major currencies. That would be the currency's biggest annual gain since 2015, when it jumped 9.5%. At one point this year, the greenback traded at levels not seen since May 2002. This year's gains came as the Fed lifted interest rates to fight a 40-year high in inflation. However, the dollar has cooled off dramatically since reaching those 20-year highs in September. Since then, the greenback has fallen more than 9%. Billionaire investor Jeffrey Gundlach said he thinks the dollar has already reached a top and that it should continue to weaken. "I do think the dollar has peaked out ... which does suggest that investments in emerging markets like emerging market equities are probably going to be a good winner in 2023," Gundlach, the CEO of DoubleLine Capital, said Dec. 6. "It's time to buy emerging market equities if you have an annual allocation switch. ... I really do think the time is right." Another potential catalyst for emerging markets could come in the form of a recovery in the semiconductor industry, which would in turn boost stocks in Taiwan and South Korea — two major industry hubs. Semiconductor companies have been hurt by continued supply chain disruptions as well as supply/demand imbalances. On Wednesday, Micron Technology reported weaker-than-expected quarterly results, with management noting : "The industry is experiencing the most severe imbalance between supply and demand in both DRAM and NAND in the last 13 years." In the past year, the VanEck Vectors Semiconductor ETF (SMH) has dropped more than 34%.However, MRB Partners' Nakhjavani thinks that the industry downturn could reach a bottom over the next two quarter, priming it for a strong second half of 2023. "That would help South Korea and Taiwan," he said. The iShares MSCI Taiwan ETF (EWT) has fallen nearly 40% in 2022, while the EWY — which tracks the South Korean stock market — has shed 27%. 'A game of two halves' To be sure, not everyone is as sanguine on emerging markets. David Lubin, head of emerging markets economics at Citi, thinks emerging markets can have a good year in 2023, but only after a rocky start due to continued hawkishness in U.S. monetary policy. "Emerging markets in 2023 looks to us like a 'game of two halves', with the latter part of the year arguably much more benign for investors than the start," he said in a note earlier this month. "The most obvious near-term question for EM is whether inflation remains a big enough threat to need more monetary tightening. We think not, due to an overall weak growth outlook, though central banks will remain wary of anything that could spark an acceleration." "What EM wants, ideally, is to get to a place characterized by both loosening U.S. monetary conditions and a strong recovery in China. Since we think that these two conditions won't properly materialize until the second half of the year, the nearer term will remain characterized by a strong dollar, tightening U.S. monetary policy and Chinese uncertainties related to both Covid and real-estate investment," Lubin added. The Fed hiked rates through 2022, with other central banks following suit in their respective regions. Most recently, the Bank of Japan changed its yield curve control policy to allow the 10-year Japanese government bond rate to move 50 basis points above or below its 0% target. The news sent ripples through global financial markets , pressuring risk assets. "The move was taken as an indication that no central bank could be relied on to remain dovish," said Mark Haefele, global wealth management chief investment officer at UBS. Meanwhile, the Fed indicated at its December meeting that it sees the " terminal rate " — the level at which it would feel comfortable stopping its rate hikes — at 5.1%. That's a half point higher than a September forecast for a terminal rate of 4.6%. How to play emerging markets in 2023 Regardless, there are several ways for investors to get exposure to emerging markets. Perhaps the easiest way is by investing in the iShares MSCI Emerging Markets ETF (EEM). The fund is invested in more than 1,200 companies across a host of developing markets. Alibaba, Vale, Tencent and Taiwan Semiconductor are among EEM's biggest holdings . The fund — which has an expense ratio of 0.68% — is heavily exposed to China, with the country accounting for 31.55% of its total market value. Another vehicle through which to play emerging markets is the First Trust Emerging Markets Small Cap AlphaDex ETF (FEMS) . The fund is the best-performing emerging markets ETF this year, according to Morningstar, with a year-to-date return of just over 1%. It also has a strong track record, outperforming 98% of funds in its category over the past 10 years. Its expense ratio comes in at 0.8%. The ETF's managers assign different weightings to its holdings based on "what we view as favorable growth and value characteristics," said Ryan Issakainen, senior vice president at First Trust Portfolios. Other variables such as price to book and return on assets are also taken into account when assigning weights. For investors looking to invest in individual emerging markets, they can turn to the iShares MSCI ETFs tracking markets such as Turkey, Mexico, and South Korea, for example. And, while buying shares of individual companies can be difficult, some of the biggest EM companies are also listed on U.S. exchanges, among them JD.com , HDFC Bank , Petrobras and SK Telecom . Shares of Chinese e-commerce company JD.com have dropped about 18% year to date, but are up more than 14% in the fourth quarter. India's HDFC Bank, meanwhile, has had a stellar 2022, gaining just over 3%. Petrobras is only down 5% year to date, while South Korea's SK Telecom has dropped 22%. — CNBC's Michael Bloom contributed to this report.