The emerging market equity asset class seemed to reach a turning point more than once in recent years, only for hopes to be dashed. But we believe risk is priced in and downbeat sentiment towards the emerging market asset class leaves it well-placed to make further progress. Foreign equity investment now is low relative to historical levels.
The following factors point to a more favourable outlook for emerging market equity returns.
There is clearly a strong inverse relationship between the dollar and the performance of emerging market equities. A strong dollar is generally a headwind for the emerging market asset class as it makes servicing dollar-denominated debt more expensive and can lead to a reversal of capital flows. The situation now resembles closely the period in which the dollar peaked in the early 2000s, preceding a stellar run for emerging market equity returns.
However, we don’t need the dollar to fall for the emerging market equity asset class to succeed, we just need it to stop rising as steadily as it has over the past 10 years. With Fed Reserve rate cuts under way, we are starting to 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 before. This is important for emerging market equities, which tend to outperform in a dollar downcycle over a multiyear period.
Stronger fundamentals
Substantial progress has been made on the macroeconomic front, monetary and fiscal, and in corporate fundamentals in recent years. At the macro level it is widely recognised that many emerging market central banks have navigated the recent hiking cycle skilfully, moving proactively to tackle inflation before their developed market counterparts.
Due to benign inflation dynamics, prospects for further rate cuts for emerging markets (both absolute and relative to developed markets) provide a cyclical tailwind for emerging market equities. The reduction in cost of capital should also help stimulate economic and business activity in emerging market economies.
At the corporate level we have also seen a push for higher standards of operating performance and corporate governance. Chinese companies are becoming more shareholder friendly and investable. Yet this is a market in which rock-bottom sentiment means even good businesses appear to be trading at attractive valuations.
Structural tailwinds
Supportive tailwinds for emerging market equities include rising income levels in emerging markets, 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. The shift to a new multipolar world economy means some emerging markets, such as Mexico, Vietnam and India, are already starting to benefit, returning an average 20% since the start of 20231.
Other multidecade structural themes that could generate long-term value for emerging market equity investors include technological development, a drive towards net-zero, efforts to enhance supply chain resilience, government stimulus and infrastructure expansion. Together, these have heralded a new capex supercycle.
Emerging markets are expected to deliver higher earnings growth than most other major regions over the short to medium term, with about 20%-plus earnings growth forecast in forward year one and high teens in forward year two. That’s higher than what’s on offer in developed market equity markets (for example, 10.9% and 14.6% for MSCI US; 5.5% and 9.9% for MSCI Europe, for financial year one and two respectively).
Compelling valuations
Emerging market equity valuations have been attractive for some time with metrics such as 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. Valuation alone is not a signal, but sets the right starting point for other conditions to drive a rerating, especially as the gap between emerging markets and the US is now near its widest in 40 years after the exceptionally strong run in US equities.
While the investment case for the emerging market equity asset class is strong, risks could drive up market volatility and delay a turn in the cycle. These include the US election outcome in November and resulting implications for emerging markets; 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.
Emerging market 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 about 20 years ago that preceded a bull run.
The authors are portfolio managers at Ninety One.
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