Emerging Markets: Has the Time Come?

28 January 2024

At last year’s BRICS Summit in South Africa, national leaders were all smiles; ushering in what they believe will be a more influential era for the Global South. Emerging market investors, on the other hand, have had little to celebrate, as EM markets have dramatically underperformed during the past 15 years — now reaching extreme levels (next Chart).

Is this about to change? First of all, it’s easy to overstate EM’s recent underperformance. Indeed, during the past 2 to 3 years, the divergence between surging US equities and slumping Chinese shares accounts for most of EM’s disappointment. Last June, I recommended global investors should begin slowly to increase allocations to developing nations. Since then, EM ex China has outperformed the developed markets ex USA index (“Asia: Will Global Growth Engine Outperform?”).

Now, I believe it’s time to go overweight EM markets. To be sure, I am still bearish on China’s near-term growth propects — a view that won’t change until Chinese policymakers do more to stimulate household consumption. However, both global and domestic market drivers have become more favourable than in recent years.

Global Drivers: Mixed, but More Positive

EM markets fare best when world-wide economic activity (and international trade) is strong, EM GDP growth outpaces DM gains, global interest rates are declining, and the US dollar is weak. All of these factors have been headwinds in recent years, but some are set to change.

First of all, the US Federal Reserve’s recent policy pivot paves the way for lower US (and eventually global) interest rates in 2024 and beyond. However, it’s quite likely the pace of monetary easing may disappoint financial markets in the near term. Meanwhile, as American yields will decline faster than in other G7 nations, the US dollar should depreciate up to 5% in 2024.

On the other hand, I expect 2024 global economic growth to remain sluggish; especially led by decelerating US GDP gains following 2023’s resilient performance. Despite this headwind for EM markets, the gap between EM and DM GDP growth in 2024 will be the widest in a decade (Chart above). Indeed, the differential will be the greatest since the Naughties — a period of consistent EM equity outperformance.

Indeed, the IMF forecasts that 70% of global growth will be generated in Asia (not to mention the other EM contributions). Nevertheless, there is no disputing that weak global growth will continue to be a headwind near term, especially for the export-oriented Asian countries most reliant on world trade (next Chart).

Domestic Drivers: Resilience and Disinflation

With exports remaining constrained, EM nations will need to rely on domestic demand to support GDP growth. Fortunately, consumer spending has remained resilient, despite higher food and energy prices (helped by government subsidies in many cases) — next Chart.

On the other hand, uncertainty about Chinese and global growth prospects has limited the recovery in business investment (next Chart). As global prospects improve in 2025, however, EM capex should rebound strongly.

Meanwhile, EM central banks have succeeded in lowering inflation, and virtually all EM countries should achieve their inflation targets by the end of 2024 (next Chart). Of course, there are exceptions. On the one hand, China and Thailand confront deflationary pressures. At the other extreme, Argentina and Turkey are undergoing macro-shock therapy to get a grip on surging prices. Central European nations, along with Colombia and Chile have more work to do. The promising inflation outlook is already allowing most EM central banks to ease monetary conditions. Significant cuts in interest rates are expected in Mexico, Brazil, Peru, Chile, South Africa, China, and Indonesia.

All countries used budget stimulus to offset the economic impact of the pandemic. As the dust settles, however, EM countries have lower (and more sustainable) government debt burdens than in advanced economies (Chart below). As a result, EM has more “fiscal space” to stimulate growth, if activity falters. Likewise, if markets become concerned about global fiscal sustainability, EM appears less vulnerable. Again, there are exceptions, noteably China, Brazil, South Africa, and Poland.

China: The Elephant in the Room

Everyone now agrees that China’s long-term growth potential has slowed to 4% at best. And, I believe China will struggle to grow 3% during the next couple years, as the nation manages the deflationary pressures of debt deleveraging. I will remain bearish on China’s economy until policymakers prioritise support of households rather than State-Owned Enterprises (see my earlier blogs, including “China: Slowdown Just Beginning”).

This raises important questions for EM and global investors. Most importantly, which countries will be most adversely impacted by China’s secular slowdown? Vietnam, Malaysia, Korea, Taiwan, and Singapore appear to have benefited most from deepening economic ties with China in the past 25 years (Chart above). As the earlier Chart illustrates, these countries (along with Indonesia and the Philippines) have suffered the sharpest declines in exports during the past year.

Geo-Fragmentation: Legacy of Covid and Ukraine

In addition, rising Sino-US political tensions, the impact of Covid on supply chains, and the war in Ukraine have cast doubts on the benefits of globalisation. Political and economic considerations have led many Western corporations to reconsider outsourcing production to China, and to shift supply chains towards “friendlier” nations (so-called “friend-shoring”) or to bring production home (e.g. “reshoring”).

There’s growing evidence that this is occurring. In the USA, for example, foreign trade has shifted to Latin America (with Mexico the main beneficiary), Europe (higher energy exports to reduce the region’s dependence on Russia), and Canada. These gains come at the expense of China and Russia (Chart above).

In China, meanwhile, trade with Russia has soared since the invasion of Ukraine. In order to offset trade share declines with the USA (and in response to rising domestic labour costs), China is shifting its supply chains to cheaper ASEAN countries. China’s efforts to secure supplies of natural resources have led to share gains in Latin America (largely Brazil) and Africa. Arguably “less friendly” partners, e.g. Taiwan, Korea, Japan, the EU and USA have lost share in this process (Chart above). At the same time, foreign direct investment into China has slowed to a trickle in recent years.

The IMF suggests the economic consequences of global fragmentation could be substantial; with the costs of reshoring exceeding those of friend-shoring. China, Korea, Taiwan, and many other Asian nations are the biggest losers. Countries with large domestic markets (less reliant on foreign trade) will be less adversely impacted, e.g. India, Indonesia, and the USA (Chart above).

Strategic Implications

  • While signals still remain mixed, global and domestic drivers point to an outperformance of EM equities during the next 12-24 months. Overall, valuations are attractive relative to the past. And, ratings are cheap compared with the US market (Chart above). However, as superior EM GDP growth is often not reflected in commensurate corporate earnings gains (or returns on equity), EM stocks deserve to continue to trade at a discount to DM peers.
  • Emerging markets, however, are not uniform. I prefer countries with large domestic markets, those less exposed to China risks, and less vulnerable to geo-fragmentation, e.g. Mexico, Brazil, Central Europe, Vietnam, India and Indonesia.
  • China remains a huge headwind. I will remain concerned until deflationary pressures are addressed by shifting fiscal support from SOEs to households. I expect monetary and fiscal stimulus to continue in 2024. Fortunately, however, the Chinese market is already discounting a lot of bad news, and is very cheap.
  • The prospect of sharp interest rate reductions makes EM bonds attractive, especially in Mexico, Brazil, Indonesia, South Africa, and Poland.
  • In foreign exchange markets, I favour BRL, MXN, IDR, ZAR, and HUF (as well as JPY). I shy away from TWD, KRW, PHP, PLN, (as well as USD). (See my blog “Strategy 2024: Searching for a Soft Landing” for explicit EM FX and interest rate projections).