11 September 2024 Over recent years, the emerging market (EM) equity asset class has seemed to reach a turning point on more than one occasion, only for hopes to be dashed. At present, we believe risk is priced in and downbeat sentiment towards the EM asset class (foreign equity investment today is low relative to historical levels) leaves it well-placed to make further progress. There are five factors which point to a more favourable outlook for EM equity returns moving forward.
1. A powerful headwind is set to wane
It is clear that there is a strong inverse relationship between the US dollar and the performance in EM equities. A strong dollar is generally a headwind for the EM asset class as it makes servicing US dollar-denominated debt more expensive and can lead to a reversal of capital flows. The situation today resembles closely the period highlighted on the left-hand side of Figure 1, where the US dollar peaked in the early 2000s, preceding a stellar run for EM equity returns.
Figure 1. A strong dollar is a powerful headwind and the dollar is now close to 20-year highs
Source: Bloomberg, Emerging markets equities = MSCI Emerging Market, Developed markets equities = MSCI World. June 2024
Laijawalla: “However, we don’t need the US dollar to fall for the EM equity asset class to succeed, we just need it to stop rising as steadily as it has over the past 10 years. With Fed rate cuts on the horizon, we may see easing in the one-way dollar trade. While its future path is unclear and unlikely to be linear, the scope for further dollar upside may be more limited than previously. This is important for EM equities, which tend to outperform in a dollar downcycle over a multi-year period.” In a similar vein, the relationship between market cycles in US and EM equities tend to move in multi-year cycles, with the average market cycle tending to last for around eight years and the current US leadership cycle is now in its 13th year.
2. Stronger fundamentals
Substantial progress has been made on the macroeconomic front – both monetary and fiscal - and in corporate fundamentals in recent years. At the macro level, it is widely recognised that many EM central banks have navigated with skill the recent hiking cycle, moving proactively to tackle inflation ahead of their developed market counterparts. Thanks to benign inflation dynamics, the prospect of further rate cuts for emerging markets (both absolute and relative to developed markets) provides a cyclical tailwind for EM equities. The reduction in cost of capital should also help stimulate economic and business activity in EM economies.
At the corporate level, we have also seen the push for higher standards of operating performance and corporate governance. For example, Chinese companies are becoming more shareholder friendly, and more investable as a result. Yet this is a market where rock-bottom sentiment means even good businesses appear to be trading at attractive valuations.
Hart: “The increased levels of share buybacks and dividends paid out paints a positive picture and signals that management teams believe their shares are undervalued by the market and see better growth prospects and cashflow generation in the coming years. This improvement in corporate governance, along with higher standards of operating performance, has been evident in the broader EM equity asset class.”
Figure 2. Dividends paid out by Chinese companies (Rmb bn)
Source: Wind. CICC, June 2024
3. Structural tailwinds
Supportive tailwinds for EM equities include rising income levels in emerging markets, along with the associated increased demand for products and services. Global economic momentum is shifting away from advanced western economies towards emerging markets, as they constitute a larger share of economic activity and are forecast to deliver higher GDP per capita growth than the developed world. Furthermore, the shift to a new multi-polar world economy means some emerging markets, like Mexico, Vietnam and India, are already starting to benefit, returning an average 20% since the start of 20231.
Other multi-decade structural themes that have the potential to generate long-term value for EM equity investors include technological development, drive towards net zero, efforts to enhance supply-chain resilience, government stimulus and infrastructure expansion. Together, these have heralded a new capex super-cycle. Laijawalla continued: “Companies that win in this environment are likely to look very different to technology leaders of the last cycle. These trends will likely create rich alpha opportunities for investors in the EM equity asset class”.
4. Robust earnings growth
Emerging markets are expected to deliver higher earnings growth than most other major regions over the short- to medium-term, with around 20%+2 earnings growth forecast in forward year 1 and high teens in forward year 2. That’s higher than what’s on offer in DM equity markets (e.g., 10.9% and 14.6% for MSCI USA; 5.5% and 9.9% for MSCI Europe, for FY1 and FY2, respectively).
5. Compelling valuations
EM equity valuations have been attractive for some time now with metrics like Price/Earnings ratios among those that have not changed much in 10 years. Part of this is driven by Chinese companies, including those that are high quality, that are now trading on depressed multiples, as noted earlier. Valuation alone is not a signal, but it sets the right starting point for other conditions to drive a re-rating, especially as the gap between emerging markets and the US is now near its widest in 40 years following the exceptionally strong run in US equities discussed earlier.
Risks to navigate
While the investment case for the EM equity asset class is strong, there are risks that could drive up market volatility and or delay a turn in the cycle. These include the US election outcome in November and resulting implications for EM; higher-for-longer rates in the US should inflation prove to be stickier than expected; policy missteps; and further lacklustre economic growth from China despite recent fiscal and monetary stimulus.
Short-term fears and souring sentiment from further geopolitical headwinds could overshadow longer-term considerations, delaying a turnaround for the asset class. However, it would also provide opportunities for bottom-up stock pickers. Hart: “While political uncertainty prevails and the economic outlook is mixed, we believe much of the risk is already priced into equity valuations. Furthermore, the divergence in sector, country and stock performance is high, creating a favourable environment for stock-pickers.”
“EM equities have been in a more-than decade-long bear market relative to developed market stocks. With a caveat about the difficulty of timing inflection points, the building blocks for a turnaround are falling into place, with parallels to the point some 20 years ago that preceded a bull-run. While timing will always be uncertain and various macro and geopolitical risks will need to be navigated carefully, a market regime shift does appear to be on the horizon,” Laijawalla.
To read more from our Deliberating EM Equities series, click here.
1Cumulative MSCI Index returns from 1 January 2023 to 30 June 2024, Bloomberg.
2Source: FactSet, as at June 2024, for all earnings growth forecasts listed in paragraph.