“Higher-for-longer is harder for longer for emerging market (EM) assets as resilience doesn't necessarily translate into portfolio flows," the analyst said. "Single-digit upside for EM fixed income and equities begs the question: why bother investing in EM when one can get +5% in US fixed income?” [1]

“Why bother?”

While short-term factors may have diminished EM appeal for some investors, we remain optimistic about the prospects for EMs in Q2 and the foreseeable future. The underperformance of EM equities for two consecutive years means the discount to developed market (DM) equities is now at historic lows (Chart 1).

Source: CLSA, January 2024.

 

The current higher-for-longer interest rate environment is not sustainable in DMs due to high debt burdens. Fed Chair Powell recently stated that continued strength in the US labour market simply isn’t enough reason to hold off from cutting rates [2]. Therefore, with the interest rate cycle expected to turn, we anticipate investors will start looking at EMs more actively.

As we look ahead, we believe three key themes support our positive EM outlook.

Peaking US rates

After showing exceptional resilience in 2023, the US economy is likely to slow (although avoiding a significant downturn). Due to massive public debt, US fiscal policy has little room to support decelerating growth. The Fed will likely do most of the heavy lifting by gradually lowering interest rates while remaining cautious about cutting too soon or too much. Any weakness ahead for the US dollar would be a boon for EM countries as it lowers their cost of capital.

With inflation near target levels in many parts of EMs, central banks are positioned to begin cutting interest rates ahead of the Fed. Poland, Brazil, and Chile have already pulled the trigger. We believe this will support EM economies, as evidenced by the real interest rate differential (Chart 2).

Source: CLSA, December 2023.

Since 2006, EM relative earnings growth has been led by the real interest rate differential between EMs and DMs. As things stand, the rate differential suggests EM earnings are set to outpace DM over the next year.

Moreover, EM corporate balance sheets have emerged stronger from the pandemic. By contrast, US corporates, which utilized ultra-low interest rates to raise debt and fund share buybacks, are now facing a higher cost of borrowing and debt servicing. Meanwhile, EM valuation multiples are already depressed, implying there’s scope for a significant rotation back into EMs.

As markets take a more discerning approach over time, a wider gap should open between stronger and weaker businesses. We believe this supports a quality-focused investment approach.

Investment tailwinds

We believe the time may be ripe for EMs to emerge and take their turn in the spotlight thanks to the following factors.

Hardware-led tech cycle

Past and recent cycles were led by e-commerce and software. By contrast, the current tech cycle is driven by the application and integration of artificial intelligence (AI). This is a hardware-intensive story that will have a significant impact on EMs. Many EM countries are home to the world's leading manufacturers of microchips and/or components to make associated parts. Many should benefit as countries and companies ramp up spending on AI.

Transition

The scope for investing capital in resource-rich EMs is shifting. The push for green transition is driving investment into renewables and related infrastructure. Projects include building power grids that rely on clean energy or creating a network of electric vehicle charging stations. Many of the essential materials required for greener technology, such as copper and platinum, are mined in EM countries, particularly Latin America. Demand for copper, used in solar photovoltaics, wind, grid-battery storage, and more, is forecast to rise from around 25,000 kilotons in 2022 to nearly 40,000 kt by 2050 (Chart 3) [3].

Nearshoring

We’re also seeing an uptick in capital expenditures (CapEx) on the back of companies de-risking their supply chains (Chart 4).

Source: Datastream Refinitiv, CLSA, December 2023.

Multinational corporations are diversifying their sourcing due to geopolitical risks, the need for post-pandemic operational resiliency, and higher wages in China. Many are adopting a ‘China plus-one’ strategy, shifting some production from China to other low-cost EMs. Supply chain diversification should drive foreign direct investments and boost manufacturing. This will bolster EM countries and support a domestic earnings recovery.

India to the fore

China’s difficulties have shone a spotlight on other EMs. India remains an emerging star, underpinned by a robust domestic economy showing strong momentum. Companies seeking to reduce their reliance on China are relocating their operation to India, attracted by its young and educated workforce and the large domestic markets. Close geopolitical ties with the US are encouraging and bode well for future trade. Meanwhile, inflation is under control and the central bank is poised to cut rates. One potential risk is the upcoming general parliamentary election. However, the incumbent government is expected to retain power, ensuring policy continuity.

China’s consumption recovery underway

China's 2023 performance served as a reminder of the inherent volatility within EMs. While there are genuine reasons for concern, a disconnect has emerged between sentiment – as indicated by valuations and headlines – and the economic reality on the ground.

Consumption and manufacturing indicators were showing signs of improvement towards the year-end. Activity data have been signalling that the economy has found a firmer footing. Despite this, onshore names are trading at historically low valuations.

We are confident in China’s economy for the following reasons.

Pace of recovery

Over the last three years, Chinese companies have encountered unprecedented challenges around Covid, weak demand, and operational issues. Yet, exports are strong, retail sales are increasing, and savings rates are normalising. Earnings growth compares favorably to other equity markets with earnings in China growing faster than the US last year and expected to do the same this year (Chart 5).

Policy support

China's government has implemented various targeted measures to support specific sectors like consumption and property. While we’ve yet to see large-scale, direct fiscal stimulus, the cumulative effect of these initiatives should not be underestimated.

We anticipate continued or increasing support to boost confidence and activity, as the Chinese economy shifts towards consumption and value-added manufacturing.

Property turnaround

The property sector has been a major drag on the Chinese economy. But measures like easier mortgage access and urban renewal plans are expected to stabilize the market in the long run. We expect, in time, to see a turnaround due to the vast pent-up demand for property, particularly in Tier 1 cities [4]. This should boost consumer confidence and spending.

Final thoughts...

We remain confident, and beginning to see evidence, of the long-term potential of EMs. Central banks are set to cut rates ahead of the Fed, boosting economic activity. The green transition and de-risking of supply chains are leading to increased capital allocation towards resource-rich EMs. Many EM companies are at the forefront of future trends, from renewable energy to the semiconductors vital for 5G and AI. Valuations, meanwhile, are at historic lows.

So, it's not a question of whether you should bother with EMs, but rather can you afford not to?