Emerging markets have trailed their developed market peers for more than a decade, caught in a perfect storm of weaker commodity prices, economic difficulties in China, widespread risk aversion and a febrile geopolitical climate. There are tentative signs of a turnaround for the sector, but it is increasingly diverse, and opportunities are idiosyncratic.
In the 10 years to 30 November 2023, emerging markets delivered an annual return of 2.1%. This compares to an annualised return of 8.3% from the MSCI World index. While there have been buoyant growth areas - India for example - these have generally not been able to compensate for weakness elsewhere.
In particular, China’s weakness has hit hard. It has become an increasingly dominant part of indices such as the MSCI Emerging Markets index, and had its own version of the ‘FANG’ phenomenon with companies such as Alibaba and TenCent. When a government crackdown hit these technology names, it knocked emerging markets as whole.
“Dedollarisation” is another phenomenon that changes the landscape for emerging markets.
In appraising emerging markets today, China remains a difficult area. Expectations were high for its emergence from Covid, but its recovery has significantly disappointed. The country is now struggling with deflation. Consumer prices fell 0.5% per cent in November, the steepest decline in three years.
At the same time, the country continues to wrestle with high debt in its real estate sector. The woes of developer Evergrande have become a byword for excesses in Chinese property development and the company teetered on the edge of bankruptcy before finally collapsing in August of this year.
There are other structural problems for China. It has poor demographics, with the World Health Organisation now predicting that the population of over-60s will reach 28% by 2040, due to longer life expectancy and declining fertility rates. This is likely to slow growth over the longer-term.
That said, data is starting to settle and it is possible to see some revival in economic growth for the year ahead. As with other major nations, wealthier Chinese households built up excess savings during the pandemic. Unlike elsewhere, those savings remain largely unspent. There is still pent-up demand for travel and leisure activities, which could support the Chinese consumer in the year ahead.
Equally, it is possible that the Chinese government will introduce stimulus measures. However, the government remains nervous on the side-effects of wider stimulus measures, such as interest rate cuts. We believe any measures will be targeted rather than broad, focused on the government’s strategic ambitions in computing, AI and renewable energy.
The market has seen two years of significant declines and valuations are low. However, there is still a fragility to the Chinese economy that cannot be ignored. At such a significant weight in the index, it remains an argument against a broader allocation to emerging markets.
Elsewhere there are better signs for emerging markets. In aggregate, their economies are likely to outpace developed market economies in the year ahead. The IMF predicts advanced economies will show growth of 1.4% in 2024, against 4% for emerging economies.
A key point of differentiation in the year ahead is likely to be inflation. A number of emerging markets are seeing fewer inflationary pressures than developed markets, giving their central banks significant capacity to cut rates. While developed markets are still making the trade-off between interest rates and economic growth, these emerging markets are a step ahead.
Brazil, for example, is one of the few countries with positive real interest rates (interest rates after inflation). Its inflation is running at around 5%, with interest rates set at 12%. The central bank expects inflation to continue to fall. It has already start to cut rates and there is scope for further cuts ahead. This should improve business conditions. Chile and Peru are following a similar cycle.
There are also longer-term considerations for emerging markets. There had been a concern that deglobalisation could see emerging markets weakened, but in reality, supply chains are simply moving to other parts of emerging markets – Vietnam, Mexico, India. This is changing the opportunity set. Specific emerging markets may also benefit from growing demand for key commodities, particularly those associated with the energy transition, such as nickel from Indonesia or copper from Chile.
“Dedollarisation” is another phenomenon that changes the landscape for emerging markets. Emerging markets are trading more closely with one-another than they have done historically, while the growing power of China on the international stage and recent sanctions on Russia have also helped break the stranglehold of the Dollar. The US Dollar may not be as powerful a medium of exchange between nations in future. This leaves emerging markets less vulnerable to volatility in the US currency and monetary policy. However, this is a longer-term consideration rather than creating an imme\diate catalyst for the sector.
Valuations are lower across the emerging market space. The MSCI Emerging markets index trades at a forward price to earnings ratio of 11.5x, compared to 16.8x for the MSCI World index. However, China skews overall valuations.
Overall, we retain a watching brief on emerging markets. There are signs that the landscape is changing, with China’s dominance fading and other countries coming to the fore. Emerging markets are increasingly diverse. There are idiosyncratic opportunities, which can be exploited through strategic positioning in both emerging and developed market companies.
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