By Victoria Harling, Head of Emerging Market Corporate Debt, Varun Laijawalla, Portfolio Manager and Grant Webster, Co-Head of Emerging Market Sovereign & FX
In times of uncertainty and dislocation, emerging markets often stand in the Crossfire. 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. 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.
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. Any 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.
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.
Nevertheless, 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.
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.
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.