2024 Investment Views: EM outlook

Emerging markets: favourable currents strengthening beneath choppy waters

At a global level, the path immediately ahead could be choppy. But beneath the surface, currents that favour emerging markets are gathering force, explain Victoria Harling, Varun Laijawalla and Grant Webster.

27 Nov 2023

15 minutes

Victoria Harling
Varun Laijawalla
Grant Webster

EM outlook

Watch Grant, Victoria and Varun discuss the macro environment, what to keep an eye on in EM equities, and opportunities in fixed income.

Chapters

01
Overview
02
Equities
03
Fixed income
01

Overview

In times of uncertainty and dislocation, emerging markets often stand in the crossfire1. Given the state of geopolitics and the radical reset of borrowing costs, the present moment would surely qualify as uncertain and dislocated. Yet in many ways, developing nations face the future in an enviable position.

With emerging countries much further along in their economic cycles, many EM central banks are already embarked on policy loosening. Monetary policy works with a lag, typically of 12-18 months, so the positive impetus of 2023’s easing could start to be felt in the months ahead. But whenever it materialises, it will likely manifest in the developing world before the US and other advanced economies experience similar effects. As we suggest in our ‘Macro outlook’, the latter may yet have a higher price to pay for the shift into a new interest-rate regime, particularly in terms of growth. On a relative basis at least, emerging markets can head into a new year with some confidence.

At a global level, then, the path immediately ahead could be choppy. But beneath the surface, currents that favour emerging markets are gathering force. We think this is a good time for fixed income and equity investors to review their EM allocations.

Potential turning points

Timing turning points is always difficult. But at the start of a new year, there is a reasonable chance that three major headwinds for EM investors could begin to turn into tailwinds.

First, a change in the trajectory of the US dollar would be a significant boon. The strength of the US currency has been a headache for EM equities, EM local-currency bonds and EM economies generally for an extended period (see Figure 1). As the IMF has noted, an appreciating greenback hurts GDP growth in emerging economies much more than advanced ones, and for much longer2. Trying to predict exactly when the US dollar might revert can make a fool of anyone – as the top-callers found in the summer of 2023 when the currency dipped, only to resume its rise. But we can certainly say that the US dollar enters 2024 with a valuation that looks extended.

A decade of US dollar appreciation

Figure 1: US dollar real effective exchange rate

Figure 1: US dollar real effective exchange rate

Source: Bloomberg, as at 30 September 2023.

After a year of recurrent anxiety about China, stabilisation of the Chinese economy – of which we think there is a fair chance in the next 12 months – would also spur developing economies. Policy tightening to address the imbalances of China’s growth model of the last three decades has had a materially negative impact in the past year, and China is not out of the woods yet. The bigger picture is that the country remains in a multi-year transition to a more domestically driven, higher value-add economy. Its leadership is extremely incentivised to ensure this transition proceeds, which requires adequate nominal growth. We think they are capable of delivering such an outcome and that Chinese domestic consumption growth should level out in 2024.

Finally, for EM fixed income investors in particular, market expectations of gradually slowing global growth, lower inflation and lower interest rates in 2024 would be a strong positive, presenting opportunities to earn the additional carry that these markets offer against a less volatile backdrop.

Current valuations also suggest an attractive entry point. But with risks remaining to global growth, inflation and geopolitics, a flexible, bottom-up approach is vital in a year when some central banks will be cutting rates and others will still need to be hiking, and where some economies will be more resilient than others. As noted earlier, our ‘Macro outlook’ posits that the coming period may be less benign than markets are discounting. Even so, getting through the top of this US interest-rate and inflation cycle should mark a sea-change in bond markets after a brutal period, EM fixed income markets’ outperformance of developed bond markets in 2023 notwithstanding.

Solid foundations

Whatever the next 12 months bring, investors can take comfort that the starting point for emerging markets is generally a robust one. Many emerging economies have solid fundamental foundations, partly as their response to COVID was necessarily more fiscally conservative than developed economies. Based on our EM Fixed Income team’s measures of credit vulnerability, fundamentals are at their strongest levels since 2014: fiscal strength is seeing the biggest improvement, with prudent policymaking resulting in increasingly healthy primary fiscal balances across EM economies, and debt-to-GDP stabilising at modest levels. Meanwhile, the more fragile emerging nations are well supported by the International Monetary Fund and other multilaterals. Overall, EM central banks have emerged from the turbulence of the post-COVID years with enhanced credibility, and in many cases developing nations’ fundamentals are in the best shape in years. The same cannot be said of many advanced economies.

Emerging market corporates are also in good shape, with lower leverage relative to comparable developed market businesses, putting them in a robust position to navigate tougher economic environments. They reduced leverage and shored up balance sheets when business was booming, secured cheap finance when rates were low, and are benefiting from that now.

Risks and opportunities

There are clearly risks for EM investors. Not least among them is the potential for the conflicts in Eastern Europe and the Middle East to widen. Meanwhile, the transition to a new equilibrium in the US’ and China’s relative power status has years to run, likely driving higher macro volatility. Amid all of this, Bloomberg3 calculates that some 40% of the world – whether measured by population or GDP – will head to the polls in 2024. Of the 40 scheduled national elections, 17 will be in emerging markets.

Finally, as we suggested, from an economic perspective, expectations for a soft landing and gradual global slowdown may prove wishful thinking. A recession is by no means off the table.

Election year

EM countries and regions heading to the polls in 2024 (general, presidential and local elections)

Venezuela’s elections are scheduled for sometime in H2 2024

Election year

Source: Ninety One, Bloomberg, Citigroup.

Nevertheless, as we explore throughout 2024 Investments Views, for investors with a moderate horizon we see positive beta and alpha potential in emerging markets, in both equities and fixed income.

We also see excellent opportunities for longer-term investors to build exposure to the structural changes that are unfolding across the developing world, including the transition to a lower-carbon economy.

From a wider perspective still, global economic momentum continues to shift away from advanced western nations as emerging markets constitute a larger share of economic activity. If nothing else, the next 12 months should provide ample opportunities to start thinking how to re-orient portfolios for a changing world in which emerging markets will play an ever greater role.

1Ninety One Investment Institute, ‘In the crossfire: revisiting the investment case for emerging markets’, November 2022.
2www.imf.org.
3www.bloomberg.com.

02

Equities

Turnaround potential building for EM equities

EM equities have been in a more-than decade-long bear market relative to developed market stocks. With a repeated caveat about the difficulty of timing inflection points, the building blocks for a turnaround are falling into place.

First, some emerging markets, like Mexico, Vietnam and India, are already starting to win big in the new multi-polar world economy. Second, if as expected the US economy continues to weaken, upward pressure on the US dollar will likely end – which, as we noted, has been a longstanding headwind for emerging markets. EM equities tend to outperform sharply in periods of US dollar weakness, because of the beneficial impacts on credit and trade in emerging markets. Third, with policy ‘normalising’ in developed markets and policy easing in emerging markets, the 15-year advantage of rock-bottom interest rates enjoyed by developed market companies will fade. Finally, EM equities are an early-cycle asset class and tend to perform strongly as the world recovers from a recession. As our Macro strategists commented, after the long famine, the feast may be beckoning.

Those entering EM equities now would need to do so with full awareness that the next 12 months could be rocky. But with sentiment towards the asset class subdued at best, there are plenty of good EM companies with long-term potential whose shares look inexpensive to us. Or, as one of our equity portfolio managers put it in Investment Views, “you’re buying an asset class which is on its knees in terms of valuation, and where companies’ returns on equity and margins are heading north. So you’re getting more for less, effectively… if you can stomach it”.

What to watch in EM equities

By region, we think Latin American equities should continue to be buoyed by falling interest rates. We also see opportunity in China. We may be close to peak negativity on China, politically, economically and towards companies. A Chinese cyclical recovery is not priced into Chinese equities, and as we noted earlier we think China’s authorities have the potential to deliver one. Among the areas of the large and diverse Chinese equity market (there are c.4,000 listed Chinese companies) that some of Ninety One’s investors are watching with interest, we would highlight the energy transition; the shift to consumer premiumisation; and travel, with flights from the US to China still one-tenth of the number pre-pandemic.

More broadly, geopolitical tensions, in tandem with shifting domestic politics, are changing the EM equity opportunity set. For example, with some companies looking to reduce the exposure of their supply chains to US-China relations, there are industries in India today that barely existed five years ago – such as the manufacture of Apple products. The challenges of investing in India include valuations, governance and geopolitics. But on-the-ground research has produced some interesting candidates for our portfolios. Meanwhile, Mexico has never done more business with the US.

Finally, South Korea has been the poster child for equity cheapness for a long time. A lot of the ‘Korean discount’ to global equities – partly a function of corporate-governance standards and historical approaches to capital allocation by Korean management teams – is justified. But Korean equities could be a wildcard pick on a medium-term horizon as the country is up for potential elevation from emerging market to developed market status. For more on where our portfolio managers see opportunities, see our video on the investment outlook for emerging markets.

By industry, some large technology companies in emerging markets (falling not only within the IT sector, but within consumer discretionary and communication services too) have interesting return potential. Separately, parts of the industrials sector stand to benefit from a strong investment cycle in the Middle East, as well as investment in the resilience of supply chains and the energy transition.

Lastly, we would just record the habitual reminder that the EM country group is extremely heterogeneous. We would justify writing an EM equity outlook on the grounds that global investors often think about it as a single allocation within their portfolios. But recent returns have varied widely, and so do the outlooks. As the chart in Figure 2 shows, amid the top-down equity narrative of US hegemony of recent years, some EM stock markets have quietly outperformed. As ever, we think selectivity and active portfolio management will be key in the year ahead.

Some EMs have quietly outperformed

Figure 2: US vs. select EM equity returns since 2020

Figure 2: US vs. select EM equity returns since 2020

Source: Ninety One, Bloomberg, as at 31 October 2023.

Accessing structural growth via sustainable portfolios

Market moves in 2023 have created some interesting valuation opportunities within longer-term structural-growth themes in emerging markets, including some that fall under the banner of sustainability.

For example, the severe deterioration in sentiment towards clean-tech companies in the second half of 2023 included among its victims (in share-price terms) a number of EM companies that are global leaders in sectors linked to decarbonisation.

Simply put, the market narrative is that higher capital costs will make the investment required for the energy transition unaffordable. This is not true: the ‘clean’ is still significantly cheaper than the ‘dirty’ in almost every market. Also, the structural trends driving the climate-solutions investment opportunity, which is well represented among emerging markets companies, remain intact. Demand for wind and solar power continues to rise. Globally, more than seven million EVs and hybrids were sold in the first seven months of 2023, accounting for 23% of all new vehicle sales.

More broadly, while the EM GDP outcome in the next year may slow or accelerate matters, it will not alter the fact that many emerging nations are pursuing policies to bring more of their citizens into the financial system and the digital economy, to extend access to healthcare, to raise the standards of housing and education, and to generally improve the lives of citizens who lack all of these things and more. For equity investors seeking to marry long-term return and impact potential, the EM investment universe presents abundant potential next year and beyond.

03

Fixed income

To generalise, the emerging markets debt story in 2023 is as follows: positive fundamentals, falling inflation and proactive monetary policymaking have resulted in relative resilience in the face of the duration bear market and a strong US dollar.

A widening of the differential between emerging markets (with typically strong balance sheets) and developed markets (such as the US, with its widening fiscal deficit) coupled with closer cooperation across emerging markets is likely to continue.

Already, emerging markets stack up increasingly favourably relative to developed markets across a variety of fundamental metrics, including debt/GDP, external balances and growth. This should underpin a stronger regime for EM sovereign debt. Similar strength can be seen in the corporate sector: over the past few years, many EM companies have built strong buffers via deleveraging, focusing on cashflows and taking advantage of cheap finance when rates were low. As a result, many EM companies are on solid fundamental foundations to withstand headwinds.

The EM fixed income asset class – especially EM hard currency sovereign debt – still benefits from a significant yield buffer relative to developed markets. This is particularly the case across high- yield markets, as spreads remain at historically wide levels despite the recent rally. In addition, market positioning remains light, which when combined with muted issuance, makes the technical backdrop (i.e., supply and demand dynamics) look more attractive. As interest-rate volatility declines, we expect to see more demand for relatively high-yielding asset classes such as EM debt.

Geopolitical dynamics

While geopolitical risks create significant uncertainty from a top-down perspective, various EM economies and companies are benefitting from commodity market dynamics and supply-chain shifts. Commodity-producing nations in particular have been aided by the fact that commodity prices have generally remained firm, recurrent doubts over the health of the Chinese economy in 2023 notwithstanding. Their relative macro stability has resulted in steady capital inflows as other countries have sought to secure supply chains. In a similar vein, EM countries are starting to come together cooperatively – with notable synergies, resulting in investment flows, between the Middle East, Brazil and China. A key driver of this is the climate transition, and specifically investments in new industries that are vital to drive progress towards net zero.

Opportunities in duration

Through a more cyclical lens, declining inflation would allow interest rates to fall in many emerging economies, providing opportunities in duration. However, a bottom-up approach will be important in a year when some central banks will be cutting rates and others will still need to be hiking, and where some economies will be more resilient than others. An inflection in US interest rates would provide further support to the EM local currency debt markets, by reducing the risk to emerging market currencies as they progress on their easing cycles. We see Latin American economies such as Brazil and Colombia benefitting most, given their still very high real rates, positive inflation dynamics and solid external balances.

EM corporate debt

In emerging market corporate debt, income is what really matters to credit investors and the compounding effect on returns when reinvesting coupons at high yields is compelling. That makes the starting point for the asset class in 2024 an interesting one.

We believe the excess risk premium seen across the asset class offers bottom-up investors a good number of opportunities, with limited supply being supportive and plenty of buyback activity boosting the market. But selectivity will continue to be key, especially against a more challenged macro backdrop.

We expect dispersion to remain, particularly in issuers and countries where bonds have been more impacted by headline risks. This has created plenty of potentially exploitable mispricings for those prepared to assume the broader risks. It is worth noting that bottom-up credit quality – in terms of credit-rating trajectories, and manageable leverage and interest coverage – continues to be robust overall. But some distressed high-yield companies will struggle to refinance over the next few years and others will prove not competitive enough to survive. Again, selectivity will be important.

Yet another likely driver of dispersion in the 12 months ahead, not just in EM corporate debt but across the EM fixed income universe, is the wave of elections in emerging markets in 2024, as we noted earlier. That adds to the case for nimble portfolios and active management, in our view.

Finally, EM credit ratings momentum has been negative in recent years, which saw downgrades among sovereign and corporate issuers and some debt restructurings in frontier markets. This has weighed on the asset class. With credit ratings now trending more positively, in time this headwind for EM fixed income should flip to a tailwind.

Authored by

Victoria Harling
Portfolio Manager
Victoria is Head of Emerging Market Corporate Debt and is responsible for managing the Emerging Market...
Varun Laijawalla
Portfolio Manager
Varun is a portfolio manager within the 4Factor team at Ninety One. He is co-portfolio for...
Grant Webster
Portfolio Manager
Grant is Co-Head of Emerging Market Sovereign & FX within the Emerging Markets Fixed Income team...

General Risks. Forecasts are inherently limited and modelling involves risks, assumptions and uncertainties, they are forward looking and are not guarantees nor a reliable indicator of future results. Actual returns could be materially higher or lower than projected. This information is not intended as a recommendation to invest in any particular asset class or strategy or as a promise of future performance. The value of investments, and any income generated from them, can fall as well as rise. Costs and charges will reduce the current and future value of investments. Where charges are taken from capital, this may constrain future growth. Past performance is not a reliable indicator of future results. If any currency differs from the investor's home currency, returns may increase or decrease as a result of currency fluctuations. Investment objectives and performance targets are subject to change and may not necessarily be achieved, losses may be made. Environmental, social or governance related risk events or factors, if they occur, could cause a negative impact on the value of investments.

Specific Risks. Commodity-related investment: Commodity prices can be extremely volatile and significant losses may be made. Currency exchange: Changes in the relative values of different currencies may adversely affect the value of investments and any related income. Default: There is a risk that the issuers of fixed income investments (e.g. bonds) may not be able to meet interest payments nor repay the money they have borrowed. The worse the credit quality of the issuer, the greater the risk of default and therefore investment loss. Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems. Equity investment: The value of equities (e.g. shares) and equity-related investments may vary according to company profits and future prospects as well as more general market factors. In the event of a company default (e.g. insolvency), the owners of their equity rank last in terms of any financial payment from that company. Interest rate: The value of fixed income investments (e.g. bonds) tends to decrease when interest rates rise.

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