We need to talk about emerging markets

Without any context you can look at this chart and come to the conclusion there is no point in having an EM allocation. A little bit more context probably doesn’t change this view much either. The return on global developed equities is massively skewed by those of US equities, so returns for almost all regions are somewhat disappointing by comparison. But then UK equities have hardly been the poster child of great investment returns, and they have delivered a better return than EM equities with less volatility. So an asset class with lower returns and higher risk …. Chocolate and teapots come to mind.

But this clearly isn’t the whole story, because otherwise pretty much any EM manager would have packed up long ago. Instead, if we look at return data that is available prior to 2012, a very different picture emerges. Returns that are more volatile, yes, but where over c.25 years you have achieved double the return on develop equities:

This graph needs to be taken with a pinch of salt. I’m not sure quite how investible an EM index would have been in 1988, and I can imagine sizeable broker fees would have been involved for most of these 25 years. But if we only look at the 2000s as a decade, you see the kind of returns for EM equities that compensate for the additional risk. This was a decade where US equities had negative returns thanks to the dot.com bubble and the GFC. It is easy to suffer from recency bias and expect US equity exceptionalism to continue, however the 2000s were a good example of when diversification into both more risky EM equities and low risk government bonds added significant value.

I won’t go into depth in this article on whether investing in Chinese companies is something that carries an existential risk. The worsening of relations between the collective west and BRICS (Brazil, Russia, India, China, South Africs) nations is well documented but the outcome is almost impossible to predict. There are currently $300bn of Russian financial assets frozen in Europe, and Russia has responded by freezing the assets of investors from ‘non-friendly’ countries. It doesn’t take too big a leap of imagination to see a situation where China does something similar.

Instead, I am examining the short-medium timeframe. Without wanting to state the obvious, there are factors which have contributed to the mediocre EM equity performance over the past decade, but these factors could become tailwinds as opposed to headwinds.

Even before we get into those there is a simple mean-reversion play. At the end of 2022, China finally re-opened following Covid, so there were heightened growth expectations. Investors piled into Chinese stocks on the expectation that growth would inflate earnings. Instead a real estate crisis has sapped confidence from both the economy and markets, with equities currently down c.-20% from January 2023, having been down over -30% earlier this year. China makes up c.28% of EM indices, so unless when investing in the asset class you actively tilt away from Chinese equities, they are bound to be a significant driver of return. With Chinese equities trading at 10x forward earnings and enjoying a little bit of recent momentum, it is easy to see upside from a valuation re-rating should no further significant bad news emerge in the coming months.

This is far from a slam dunk. My colleague Santiago Rossi has prepared both a short and long-term view on the Chinese economy and it is fair to say there are areas for concern. For the purpose of this piece, the short-term issues are important counterarguments:

• China is now facing the same property bust and deflation as Japan in the 1990s.
• Current fiscal stimulus and interest rate cuts are unlikely to be enough to restore growth to target and improve sentiment. A major bailout of banks and developers will be needed.
• Consumer confidence has plummeted. There is a structural lack of demand due to the absence of social safety nets, households have little wealth and what they do have (property) is losing value.
• Exporting its way out of trouble is no longer viable given its huge share of global exports.
• Capital outflows: China is now suffering net FDI outflows.

I won’t counter argue all of these points. The obvious caveat to all these is that economic strength doesn’t necessarily correlate well with equity returns. It is generally more important in EM than in ‘developed markets’, where we regularly see that ‘bad news is good news’, as large parts of the equity market performs well when interest rate expectations fall. Meanwhile surprisingly resilient global growth has allayed the issue of exports, which are up 5% year-on-year (YoY) in Q1, after three quarters of flat or negative gains, and the 3.8% YoY decline in March was largely driven by a high base from last year.

The point around confidence can be taken both ways. Chinese property growth is generally very important for stocks as it is a very sentiment driven market. With prices down -6% YoY there is commentary that it is difficult to see sentiment getting any worse. We all want to be able to invest when the market is most fearful.

FDI outflows is the elephant in the room. There is a real issue with outflows right now as expectations of a delay in US rate cuts is continuing the trend of onshoring of assets due to the positive US Dollar interest rate differential. Getting over 2.5% in real yields on the risk-free asset is clearly an attractive proposition. But both FDI flows and US interest rate expectations have fluctuated significantly over the past 18 months. GDP and inflation data are seemingly heading in different directions right now, with the most recent growth print disappointing but the PCE deflator higher than expected. The stickiness in inflation over the past 18 months has been more demand driven rather than the structural type that kicked off the painful period in 2022 and 2023. Therefore it seems unlikely that inflation will remain high if the economy does slow. Although not my base case, a couple of weak inflation prints could see markets once again pricing in three US rate cuts this year – indeed US yields have fallen back in the last few days on weaker than expected non-farm payrolls and wage data.

With regards to FDI flows, a bit like with sentiment, there is a question of how much worse it can get. Plus we have seen weak sentiment turn to strong sentiment turn to weak sentiment very quickly. Despite the economic concerns, it is clear that sentiment could quickly turn. And if it does there is a wider point about EM investment in general.  J.P. Morgan calculates there is a large gap between the % weighting of EM in global equities (c.10%) and the % of total AUM allocated to the region (c.5%) which has only worsened due to the disappointment over Chinese growth. A closing of this gap would be a clear tailwind for EM stocks, we just need a catalyst.

So what could be a catalyst? We may be able to find one in one of the reasons for weak EM performance in the post-GFC era. If we look at US equities over that period, yes they look expensive at times, but earnings per share (EPS) grew around 3x between 2010 and 2020. It was often described as a bull market which wasn’t built on fundamentals. True, EPS measures were inflated by cheap interest and buy backs, which is now more of an issue as the cost of financing those buy-backs has risen. However what is striking is the contrast to emerging market EPS, which is below its 2011 peak in USD, as are sales:

However this is the opposite of what we see historically (where data is available).  Emerging Markets equities had faster growth in EPS growth rates than broad global equities over the1994–2007 period. EPS growth is what fuelled strong EM returns pre-GFC. And even post GFC, when you do find periods of strong earnings growth (as outlined in the blue box in the previous chart), EM equities perform relatively well:

Earnings growth over the next couple of years now becomes important. And expected levels are not small, with J.P. Morgan expecting 13% in 2024 and 12% in 2025. This is in fact lower than market consensus, which is for 15.6% in 2024 and 15.2% in 2025. And importantly both China and India, which make up nearly 50% of EM equity market cap, are both expected to see strong EPS growth. J.P. Morgan expects China’s EPS growth to be 13% in 2024 and 12% in 2025, while they expect India’s EPS growth to be 26% in 2024 and 10% in 2025.

The other serious risk to EM outperformance is the US Dollar, as a lot of EM debt is tied to the currency so when it rises in value the amount repaid effectively rises. We once again seem to be experiencing a period of US exceptionalism, with GDP growth well ahead of other developed markets and the trade weighted US Dollar seemingly on a never-ending upward trajectory. Expectations for US rate cuts are being pushed back, while EM countries, having raised rates earlier and done a good job of taming inflation, are largely looking to make cuts. With interest rate expectations currently heading in opposite directions, there is certainly a risk that the US Dollar appreciates further against EM currencies in aggregate.

True, these days there is around 5x more EM debt issued in local currencies than in USD, however this is limited to a relatively select number of countries with sufficient credibility. And if you examine recent periods when the US Dollar has rallied, EM markets are still performing relatively poorly.

So why does this not worry me too much? First, although I stated that further US Dollar strength is a risk, I think a lot of this is baked in. As I mentioned earlier US inflation and GDP are seemingly heading in different directions, so for the same reason FDI flows could stabilise, so could US Dollar strength. And finally, despite the recent US Dollar gains, which market has been rallying? China. Whether it is valuations that can’t be ignored, excitement over potential stimulus, or just plain ‘FOMO’, it seems confidence is returning to the market. If China is rallying, a bet on EM outperformance is one I would take.

Written by James Rowlinson, Associate Director, Financial Planning