
Are the clouds clearing for emerging markets?
Investors have had to tiptoe through emerging markets in recent years. For every India and Taiwan, where stock markets have soared, there’s been a China, which has threatened to wreck the party. This has left overall returns looking unexciting, even if there have been pockets of strength. But with China’s fortunes turning, emerging markets could be a more fertile hunting ground from here.
China has been a major headwind for emerging market investors. The Shanghai Composite index has dropped 17% since the start of 2022* amid a toxic combination of a flagging property market, uncertain growth, and poor consumer confidence. Geopolitics have also been unhelpful. While trading ties with the US have remained – the US continues to import over $500 billion-worth of goods and services from China each year** – the threat of ever-higher tariffs has dented both the economy and stock market confidence.
This has weighed on the aggregate performance of emerging markets. Over five years, the MSCI Emerging Markets index is up 5.8% per year***. Knock out China, which is still around a quarter of the index, and it’s up 8.4% per year***. This may not be as high as the MSCI World, but it is a creditable performance.
China’s weakness had persisted in the face of cheaper and cheaper valuations. At every apparent capitulation point, the market would lurch lower. Then the Government and central bank surprised markets by announcing a raft of stimulus measures, sending the Chinese stock market soaring. The Shanghai Composite is up 22.6%**** in the past month alone.
Andrew Mattock, manager on the Matthews Pacific Tiger fund, says: “The People’s Bank of China, along with financial regulators, announced a wide-ranging stimulus package that included interest rate cuts, more liquidity for banks, additional property reforms as well as funding initiatives for the stock market. The package was welcomed by investors. Markets on the mainland and in Hong Kong climbed, with the CSI 300 Index—a benchmark of onshore stock exchanges—recording its biggest gain since July 2020.”
He believes the markets are right to be enthusiastic: “In the near term, we think financials and consumer discretionary companies will benefit. But the package is pretty broad. Even the policies related directly to the stock market in terms of encouraging more participation by financial institutions and buybacks, that affects lots of companies, not just discretionary and financial institutions.”
Perhaps more important is the determination it shows from the government to turn the country’s fortunes. Andrew says it is “the broadest, most aggressive set of moves that we’ve seen in three and a half years.”
Impact of interest rate cuts
With one major roadblock to emerging market performance removed, there are other reasons to be more optimistic on emerging markets. Austin Forey, manager on the JPMorgan Emerging Markets Investment Trust, points out that interest rates are dropping faster and more decisively in emerging markets than elsewhere. “With many emerging market central banks having relatively high policy rates, especially compared with domestic inflation, emerging market central banks may now have the capacity to cut rates faster, assuming inflation remains on its current downward trajectory: Brazil, Mexico, China, the Czech Republic, Chile and Hungary have already cut rates in 2024.”
Emerging markets should also be beneficiaries of cuts from the Federal Reserve, which sliced rates by 0.5% in September and has more cuts on the radar. Andrew believes this cut will provide an impetus for a number of central banks in Asia to cut their own rates: “We think this is a significant turning point for economies in the region. Fed rate cuts typically also bring downward pressure on the US dollar which is often also a tailwind.”
This is not universal. Andrew doesn’t see much impact in, for example, Taiwanese equities, which have already benefitted from the AI boom and where valuations are now a little stretched. However, it may help boost sentiment towards overlooked parts of emerging markets, which have been left behind.
Future economic growth
Emerging markets remain a source of economic growth that is hard to find in developed economies. The latest IMF World Economic Outlook shows emerging and developing economies growing at 4.3% for 2024, versus just 1.7% for developed economies^. Growth across Asian economies is particularly strong.
Rasmus Nemmoe, manager on the FSSA Global Emerging Markets Focus fund, says: “We believe it is difficult to be optimistic about global markets without maintaining a positive view on emerging markets. The global economy is increasingly driven by emerging market growth, and we expect this trend to accelerate in coming years. We remain focused on businesses with proven management teams and structurally competitive advantages that allow them to capitalise on long-term secular trends across the emerging markets universe.
“For example, the formalisation of the Indian economy, the rising level of financial inclusion in South Africa and the growing adoption of Enterprise Resource Planning systems by Brazilian SMEs represent compelling long-term growth opportunities.”
Austin says that this creates a benign backdrop for companies to grow their earnings: “After weak earnings growth in 2023 for emerging markets, driven by falling margins, higher rates and cyclical pressures, expectations are for double-digit growth in 2024-2025.”
Unlike, say, US technology, the growth on offer in emerging markets is available at much lower prices. In aggregate, companies in the MSCI Emerging Markets index are trading at a 35% discount to those in the MSCI World index***. Price to book levels are around half. Even taking into account a different sector mix, this is still a significant gap.
Even the most expensive stocks in emerging markets look cheaper than elsewhere. The semiconductor area has been caught up in the general excitement around AI, and this has seen a significant expansion in the rating for TSMC.
Austin still expects volatility around the US election. Although Donald Trump’s bark may prove worse than his bite, the threat of onerous tariffs on goods into the US may deter some investors in the short term. However, the long-term outlook for emerging markets is looking brighter.
*Source: FE Analytics, total returns in pounds sterling, 31 December 2021 to 11 October 2024
**Source: Office of the US Trade Representative
***Source: MSCI index factsheet, 30 September 2024
****Source: FE Analytics, total returns in pounds sterling, 13 September 2024 to 14 October 2024
^Source: IMF, World Economic Outlook Growth Projections, July 2024