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Written by: Sammy Suzuki. Sergey Davalchenko and Stuart Rae
It’s been a long, hard slog for emerging-market (EM) equities. Since peaking in late 2010, EM stocks have underperformed global developed equities amid a confluence of macroeconomic and market headwinds. Now, a regime change unfolding in global markets may actually help improve conditions for beleaguered developing-world stocks.
In China and across emerging markets, there is a whiff of hope in the air. Several troublesome trends that have dogged EM equities for more than a decade may be abating. Some headwinds could even turn into tailwinds for 2023 and beyond. And with valuations and earnings forecasts now sharply lower, the time seems right to look toward the developing world again. In fact, since troughing on November 1, 2022, EM and Chinese equities—which weighed on the EM index in the last couple of years—have started to outperform. Can this bounce be sustained? We think so, for the following reasons:
Economic Growth Gap Set to Widen
In the past, one of the biggest attractions of EM equities was a stronger macroeconomic growth backdrop than that of developed countries. Yet that growth differential steadily narrowed (Display) as many EM countries worked through the hangover created by China’s explosive growth in the early 2000s. EM currencies were subsequently adjusted lower, companies deleveraged their balance sheets and commodity prices fell during the following decade, which all conspired to constrain EM equity returns. These factors were exacerbated in recent quarters, as EM economies grappled with a rapid tightening of financial conditions when most central banks raised interest rates to reverse years of monetary easing. With these adjustments largely done, productivity gains and favorable demographics could reassert their influence as traditional accelerators of macroeconomic growth in EM.
Several forces could begin to change growth dynamics this year. While developed-market (DM) growth slows down, economic growth is set to remain solid in EM, bolstered in part by China’s reopening impulse. Since the 20th Communist Party Congress in October, the government has rapidly reopened the economy and reaffirmed its focus on prioritizing growth. Consumer confidence is poised to recover as COVID restrictions loosen. Meanwhile, record-high savings levels should boost consumer spending.
Taken together, these moves could reenergize China’s GDP growth, providing a lift to both earnings and equity market performance, in our view.
We’re also seeing signals of declining inflation across various EM countries, including India and Brazil. As inflation slows and the US Federal Reserve approaches the end of its tightening cycle, some EM central banks may gain the confidence to pause or reverse their own tightening cycles, which weighed on economic growth over the past two years.
Some EM economies will benefit from supply chain reconfigurations. Many companies are diversifying their supply chains away from China. This is driving manufacturing toward countries from Mexico to India to Indonesia to Vietnam. For instance, Indonesia has seen increased interest from global auto and auto-parts manufacturers drawn to the country’s vast natural resources and ability to supply key inputs for electric vehicles, such as nickel and copper. Vietnam and Mexico benefit from their proximity to China and the US, respectively, and from existing supply chain networks.
On the Margins: Profitability Differential Poised to Converge
Poor earnings growth has weighed on emerging companies over the last decade. The gulf between US and EM profitability has been especially wide since COVID began amid the dominance of US mega-caps and rising prices, which surpassed costs.
While American companies have a good track record of innovating and reinventing themselves, the hurdles to exceptional profitability will probably be higher than in the past. Weaker US economic growth, regulatory pressure on big tech and elevated labor costs could compress US margins—and contribute toward EM companies closing the profitability gap.
Currency Counts for Countries and Companies
Emerging markets are often vulnerable to swings in currency. In recent years, the strong US dollar has created multiple challenges. It made USD-denominated prices less competitive and affected the funding environment for EM countries and companies running external balances.
The US dollar appears to have peaked in September after appreciating for several years. If this trend continues, EM equities could enjoy a currency-fueled boost. That’s because historically, there has been a strong correlation between foreign portfolio flows to EM and the US dollar. If improving growth outside the US helps moderate the trajectory of the US dollar, we would expect a pickup in portfolio flows to EM equities.
Valuations and Earnings Expectations: A Solid Starting Point
Investors are understandably anxious about EM equities after several difficult years. Overcoming the uncertainty requires an answer to one key question: what is priced into current valuations—and what isn’t. Earnings expectations have declined by about 16% from their peak in 2022. In contrast, earnings expectations have not come down significantly in many global DM sectors. With the macro environment more favorable to EM again, we expect earnings growth to accelerate again. Meanwhile EM equity valuations look attractive versus their own history and developed markets (Display). At lower valuations, we believe that investors can benefit from greater recovery potential if the headwinds continue to fade and potentially even turn into tailwinds. We see “value” in growth stocks after the strong de-rating. Yet we believe that attractive opportunities can be found across the market, including in value and lower-volatility stocks.
To be sure, the road ahead won’t be smooth. Geopolitical tensions/trade war concerns could resurface as the world’s two largest economies collide while economies and companies are busy re-calibrating their supply chains. Similarly, while EM economies look healthier than during the prior taper tantrum episode, politics and populism could hinder fiscal consolidation, and with that bring volatility. So even in more favorable conditions, we believe that a highly selective, active investing approach is essential to identify EM companies with strong business fundamentals and long-term return potential. Different approaches will be suitable for different risk-return appetites and long-term goals. Identifying the right approach now is the first step toward positioning to participate in the EM equity recovery potential that could be unlocked in the years to come.