Emerging market equities: Unleashing potential

With the belief that emerging market equities are currently mispriced, undervalued and completely misunderstood, Tim Love, Investment Director, Emerging Markets Equities, thinks all that is missing is a ‘risk-on’ catalyst to unleash their potential. What kind of catalyst could that be?

13 March 2024

The obvious catalysts for emerging markets (EMs) have traditionally been centred around two key factors, the peak in the dollar and the Federal Open Market Committee’s (FOMC) decisions on interest rates. Both of these factors are likely to have an impact within the next year in my view, possibly within six months. Looking ahead, I believe there will be positive carry trade opportunities, with liquid investment grade bonds, rising yields and a wide enough spread on the EM bond index to offer an attractive risk reward versus alternatives in the developed fixed income world. I therefore think that the convergence of these factors could lead to a capital shift from developed markets (DMs) to EMs. This movement, driven by the dollar-weighted cost of capital, may set in motion a virtuous circle of investment opportunities in the EM space.

Why could EM investors benefit even more from interest rate cuts?

The US market has already priced in the expectations of an interest rate cut, while approximately two-thirds of the anticipated interest rate cuts have been factored into stock prices. The market there has surged significantly, leaving less room for further gains. In contrast, EMs have not experienced the same level of upswing. Various reasons contribute to this lag, including differences in domestic fundamentals and a lack of monetary easing over the past decade.

DMs have been benefiting from normalisation after a prolonged period of monetary easing, while EMs remain poised for potential gains, in my view. If the DMs begin to slow down, investors will seek alternatives, such as EM currencies or local currencies with attractive yields. This should drive up the price of EM currencies and their yields will depreciate as a result. It could ultimately drive capital into the equity market. I believe EM equities offer an appealing income yield compared to bonds, making them an attractive destination for investors seeking growth opportunities.

Enviable risk-return ratio

Over time, EMs have undergone enormous development. In 2004, the EM index had only four investment grade countries out of the top 11. Today, we have witnessed a remarkable transformation. Nine out of the top 11 EMs now hold investment-grade status. The recent period from 2010 to 2023 was akin to a lost decade for EM equities, comparable to the challenging years of 1994-2004, characterised by the Asian crisis that followed the Mexican crisis and the Russian crisis. Additionally, the SARS outbreak and the dotcom bubble further impacted these markets. However, a turning point arrived. Post those tumultuous times, there was a massive revaluation of EMs. Investors began to recognise their potential anew.

Interestingly, the valuations we observed back in 2003 are similar to what we see today. However, there is a crucial difference: returns. Back then, EMs were less attractive in terms of returns. Now, they offer greater value and appear more predictable, in my view. When it comes to the attractive risk-return profile, the current landscape compares favourably to 2003.

Changing earnings profile in EMs

The earnings profile of EMs has changed fundamentally, which many have not fully recognised yet. Now, it is more about semiconductors, much more about interactive media and services, much more diversified banking offerings and e-commerce. In India, for example, the focus has shifted away from state-owned telecommunications companies, oil, gas, mining and steel companies. These legacy sectors are losing ground in the index. The impact of the high-governance stocks, those with strong management and transparency, is increasingly evident. These resilient companies contribute significantly to the index.

Why have most emerging equity markets lagged behind DMs?

EMs have recently been dragged down by one particular country, and that is China. The loss of wealth there has been overwhelmingly large, and it is ideologically driven, rather than purely market driven. If you exclude China, the EMs are doing better than the industrialised countries excluding the US. For instance, the MSCI EM Latin America 10/40 Index (USD) exhibited impressive growth of 34.05% last year. The reality is that people generally opt for the easiest money. And the easiest money at the moment is US government bonds, with 5% yields on offer. However, EMs become even more attractive in terms of risk/reward because they tend to capture more upside when global growth turns around. This is exactly where we are now.

Outlook for China

The outlook for China is not good, in my opinion. Debt, deflation, demographics, unemployment, lack of foreign direct investment, even capital controls, these are all not good indicators. There will probably be a few more bankruptcies like Evergrande before we have the Lehman moment. In China's favour is that the bank balance sheets are being deleveraged, the end of the shadow lenders has come, the ironclad political support is good; the closed capital account helps. There are also still some high-quality stocks in China that are interesting from a cyclical point of view and may present investment opportunities.

India’s bright prospects

India is in many ways the exact opposite of China. The demographics and the debt profile are much more attractive. India’s unemployment rate is much lower and foreign direct investment is pouring into the country. Also, remittances from Indians abroad flowing back into the country are huge. The absence of capital controls underscores India’s commitment to open markets. Investors recognise the country’s potential and are keen to participate. India’s strategic positioning, combined with its growing middle class and expanding consumer base, suggests that it is indeed on the right track, painting a promising picture for its future.

EMs generally have fantastic demographics, with the exception of China, which is still suffering from the one-child policy. In India, it is the opposite. With an average age of 27 to 28, India has a youthful population. Less debt and a young population translate to more future taxpayers, more reform programs, more remittances, more foreign direct investment. These taxpayers contribute to economic growth and stability.

Argentina’s reformist journey

Argentina is one of my favourite topics and I spent a few weeks there in January. The country has witnessed a significant political shift with the new libertarian president Javier Milei. Milei, the equivalent of a Thatcherite reformist, has come to power with a very reform-orientated and market-friendly agenda. Despite securing a majority, Milei recognises that his political room for manoeuvre is limited. He therefore has realised that to drive through reforms, he must act swiftly.

Milei has already devalued the currency significantly, by over 40 to 50%, aligning the informal rate with the formal rate. However, Argentina still grapples with monthly inflation in the double-digit range, equivalent to an annual rate of 140%. The challenge lies in managing the delicate balance. If the official rate is lowered by 40%, there is a three-to-four month window before another devaluation and it becomes necessary. Failure to act promptly risks further depreciation in the black-market rate. The recent rejection of the omnibus economic reform bill in the National Congress of Argentina was a setback for Milei’s reform agenda.

Success in Milei’s reforms would benefit both the Argentine people and the economy. Argentina, blessed with abundant resources, has the potential to gain its status as a global powerhouse. The country is standing at a crossroads now, and the right policies could unlock its immense potential.

A good time

A re-rating of the price-to-earnings ratio (P/E multiple) could be the catalyst that brings the lifeblood of EMs back to the fore, as it did in 2004-2008. The timing now could be just as breathtaking. In my view, investors should seize the opportunity early, recognising that EMs are in an early cycle. If markets price in a soft landing and global growth gains momentum, EMs are poised to benefit. Among them, the export-orientated industrial markets, such as Taiwan, Korea and Mexico, stand out with the potential to double and triple.

Between 2003 and 2008, EMs experienced a remarkable resurgence, and not only caught up with the S&P 500 Index after a decade of underperformance, but surpassed it. The MSCI Emerging Markets Index recorded an astounding growth of 354.03% between 30 April 2003 and 30 April 2008, outperforming the S&P 500 Index’s modest growth of 50.12%. This trend suggests that EMs have the capacity to rapidly close performance gaps and leap ahead during the early stages of a new cycle. As we stand on the cusp of another cycle, I believe EMs are currently positioned at a similar valuation entry point as in the past, but with potentially even more upside.