Emerging Market Equities Are Well-Placed to Outperform

After two years of underperformance, there was great hope as 2023 commenced that this would be the year where emerging market equities would outperform their developed market peers. The re-opening of the Chinese economy late in 2022 and expectations of an early end to higher interest rates in the U.S. were key reasons for this hope. However, the Chinese economic recovery faltered, and the Fed continued to push rates higher throughout the first half of the year. Despite these headwinds, emerging markets ex China were still able to record a return of 9.0% during the first eight months of the year (MSCI Emerging Markets ex China) — not bad if one considers that large cap U.S. stocks ex the “Magnificent 7*” returned 8.4% over the same time period.

Looking forward, we see several reasons to be more constructive on emerging markets, including China, and an increased likelihood that emerging market equities could outperform developed market equities over the medium term. The troika of headwinds for emerging markets – higher inflation, higher U.S. rates and a higher U.S. dollar – are peaking, with some early signs that inflation is already turning. With expectations that U.S. rates are close to their peak, the strong rally in the U.S. dollar is also likely to run out of steam before the end of the year. Although neither U.S. rates nor the U.S. dollar will necessarily turn into tailwinds (i.e., lower rates and a weaker U.S. dollar) during the next six months, the removal of the troika of headwinds is critical to emerging markets. Historically, it has been very difficult for emerging market assets to outperform in an environment of higher inflation, increasing U.S. rates and an appreciating U.S. dollar.

Economic growth differentials between emerging market and developed market economies are expected to widen again in 2024, led by stronger growth in Asia, while the U.S. is battling a slowing economy — the so-called soft landing in the U.S. Expectations of a widening growth differential are also reflected in earnings expectations, with emerging market earnings expected to increase by double digits in 2024, compared to single-digit earnings expectations for developed market companies (19% vs 8%, according to JPMorgan).

China remains by far the biggest player amongst emerging markets, and it would be difficult for emerging markets as a group to outperform their developed market peers if the economic recovery in China fails to gain momentum. Whether this materializes during the next quarter or two will depend on policy decisions in China. We are encouraged by policymakers that have already introduced a number of small measures to start addressing problematic areas in the economy, including the property sector, consumer and private sector confidence, and local government debt. However, even taken together, the measures of the last few months fall short of a definitive turning point, and hence investors’ indifference to these measures. However, and this is key, the change in and direction of policymaking is very clear: to provide additional support to stimulate the economy. We believe this trend will continue, and more help/stimulus should be forthcoming in the near term, pushing the economic recovery back on track for around 5% growth in 2023. Better-than-expected earnings in Q3, as a result of the economic recovery gaining momentum, might well be the trigger for investors to re-engage Chinese equities.

Lastly, positioning into emerging markets remains light compared to the last decade, and relative valuation has become very attractive.

With the above in mind, we are positioned for a mild acceleration in the Chinese economy and for continued strong growth out of Asia. We are overweight China, Indonesia and India. Though Latin America is also an overweight in the fund, we have a more defensive tilt in the region, with an overweight in Mexican consumer staples. Large holdings in the fund include TSMC, Samsung, Tencent, Alibaba, Grupo Banorte and Femsa.   

*Apple, Amazon, Facebook, Google, Microsoft, Netflix, Tesla

Summary

Emerging markets were expected to outperform their developed market peers in 2023, however higher inflation, rising U.S. interest rates, an appreciating U.S. dollar, and a false start to China’s economic recovery created unexpected headwinds. As these challenges are considered to be close to their peak, their correction should also bring about ideal conditions for emerging market equities to strengthen. Emerging market earnings are expected to greatly outpace developed markets in 2024, bolstered by China’s forthcoming stimulus.