Emerging Markets: Tailwinds at last?
Michael Reynal 25-Nov-2024
Emerging markets (EM) investors are intrepid and optimistic by nature. Why else would anyone allocate to equities in such distant corners of the globe? Of course, we find the dynamics of emerging markets inherently fascinating, but we also are big believers in the diversification benefits and absolute return potential of the asset class. That’s why many institutional investors have a long-term allocation to emerging markets.
Retail investors, on the other hand, tend to be less committed to emerging markets. Perhaps this reflects the recent robust returns of our own domestic market. The S&P 500®—the default barometer of the U.S. stock market—has outperformed EM benchmarks over the past few years. Others may worry about the risk of the unknown, which keeps them focused almost entirely on companies closer to home. Behavioral economists have names for both of these predispositions—recency bias and home-country bias.
We are here to remind investors that domestic markets don’t always lead the way higher, and there are times when headwinds for emerging markets turn to tailwinds. Although we never advocate timing the market, we believe that now is an opportune time for investors and their advisors to consider rebalancing portfolios to determine if a longer-term allocation to EM equities is appropriate.
Let’s Talk China
To be clear, China is not the only story in emerging markets. Still, it is the largest component of the MSCI Emerging Markets Index* by a wide margin, representing approximately 28% of the benchmark as of the end of the third quarter of 2024. There’s no denying that China has been on a downward trajectory while navigating a host of challenges, including severe contraction in the property sector; local government debt constraining investment; and a period of deflation that has stalled the rise of the consumer/domestic consumption story. These factors have also hindered foreign investment into China, while the deterioration of Sino-U.S. relations certainly has not helped.
More recently, however, we have seen signs of a trend change (not to mention a sharp rally in Chinese equities to close out the third quarter). The trigger has been the promise of economic stability and growth thanks to a slew of new Chinese government measures. The stimulus plans include cuts to the mortgage rate for existing housing and lowering the reserve requirement ratio (RRR), which is the amount of cash that commercial banks must hold as reserves.
The People's Bank of China (the central bank of the People's Republic of China, or PBoC) also announced that it will provide a 500-billion-yuan ($113 billion) refinancing facility for stock buybacks, illustrating a massive new commitment to stabilize financial markets. There are other plans for policies to provide more liquidity and support the stock market as well.
For the Chinese economy to emerge from slowdown, it will take a coordinated approach such as this. The stimulus measures announced so far are likely sufficient to achieve the 5% GDP growth target this year, but they’re unlikely to be enough to reflate the economy. We’ll be monitoring subsequent announcements and policies, both monetary and fiscal, as well as evaluating the implementation efforts from here.
Despite the recent weakness, China’s economy is still projected to grow by 4.8% next year, according to the International Monetary Fund’s World Economic Outlook, a level of growth that exceeds any developed markets.
A Currency Boost?
We expect the emerging markets growth premium over developed markets (DM) to remain at approximately +2.4% in 2024 and 2025, amid an improving EM macroeconomic outlook. EM continues to boast a superior earnings growth differential to DM in 2024 (+13% vs. +4%). This EM advantage may decline but should remain present through 2025. Faster and deeper Federal Reserve easing will allow for greater EM rate cuts where needed. Such a global monetary policy backdrop should be constructive from a currency perspective, and it could provide further fuel for emerging markets.
Already we’ve seen a notable depreciation in the U.S. dollar’s (USD) against an array of emerging markets currencies during the third quarter, which we believe illustrates the shifting economic and policy landscapes that can benefit emerging markets. The U.S. Federal Reserve announced a larger-than-expected 50-bps interest rate cut following its September Federal Open Market Committee (FOMC) meeting and another 20-bps cut in November. The Fed and other developed market central banks appear more in alignment now—Japan notwithstanding—as they converge on the path of monetary policy easing.
In turn, we believe that key emerging markets central banks have more room to cut rates as well, due to their earlier and faster rate hikes at the initial onset of the pandemic crisis, particularly across Asia. This could further boost their own domestic consumer demand, which should provide another driver for growth. All this suggests that the macro backdrop has turned favorable for emerging markets.
EM ex-China
The emerging markets landscape is rich and diverse, and we see ample opportunities elsewhere. India is a fast-growing economy that may soon surpass the developed economies of Japan and Germany. India continues to benefit from attractive demographics and political leadership intent on attracting foreign capital.
Mexican markets may have experienced recent volatility as a result of elevated governance risk surrounding controversial constitutional changes, but the newly sworn-in Claudia Sheinbaum will look to accelerate growth while reducing the fiscal deficit. Mexico should continue to offer opportunities thanks to the near-shoring/on-shoring of global supply chains happening in tandem on both sides of the U.S./Mexico border. Brazil has benefited from a cyclical recovery boosted by both strong domestic fundamentals, as well as improving external dynamics.
Elsewhere in Asia (excluding China), South Korea and Taiwan are positioned to benefit from the artificial intelligence proliferation across the broader tech ecosystem. Meanwhile, we continue to see other opportunities in Eastern Europe, Middle East, and Africa (EEMEA), including Saudi Arabia and South Africa. And Poland continues to benefit from its stable market-friendly government almost one year after its election, which has since reestablished ties with the EU and unlocked material funding for the country once more.
The list is long, and the key point is that many opportunities exist as the economic cycles in individual countries and regions do not always move in lockstep. Yes, there will always be risks. At present, geopolitics remain the biggest near-term concern to global financial markets, in our opinion, and the election of Donald Trump to a second term could bring new tariffs that might impact various sectors and industries. There is also execution risk regarding the aforementioned Chinese stimulus measures.
But for us, gaining access to the potential diversification and growth trajectories far outweighs the risks, which we think are manageable through fundamental research and security selection.
* EM countries include: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Kuwait, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.