Historical trends have shown that both EM and Asia markets tend to outperform the US whenever the Federal Reserve (Fed) cuts rates. This is because in addition to policy support, there is also growth and earnings potential that are higher, valuations that are more attractive and exposure to currencies that have higher carry – i.e., the return obtained from holding those currencies – relative to the US dollar in a rate cutting cycle.

Three reasons why an outperformance is possible

Some of the crucial factors that have been holding back EM are starting to abate:

1. There is growing expectation for US interest rates to come down this year. Despite last year’s exceptional resilience, market expectations are calibrating around a potential slowdown in the US economy. Fiscal policy has little legroom to support any deceleration in growth, considering the massive level of US public debt. It is likely that the Fed would be expected to do most of the heavy lifting by gradually lowering interest rates. The US dollar could come under pressure and interest rate differentials over the cycle may turn more favourable for EM currencies.

This bodes well for emerging economies, many of which have high levels of US dollar-denominated debt. With inflation at target level in many parts of the region, EM central banks will be able to start cutting interest rates, allowing yields to decline from lofty levels. In fact, several EM central banks are already running ahead of the Fed with monetary easing. Fundamentals are also improving as EM countries are more resilient than before, with strong current account positions and reserves that helped them avoid another taper tantrum¹ when the Fed started raising rates.

2. Valuations in EM are at very attractive levels. EM equities are currently trading at 14.4x P/E versus 19x for developed markets², which implies there is scope for a significant rotation back to emerging markets. In fixed income, EM Investment Grade offers close to 50bps spread premium over their DM counterparts, while EM High Yield premium offers over 125bps spread pickup for similarly rated DM peers. This is further supported by an encouraging growth outlook. Emerging economies are expected to grow at an average rate of 4% in 2024 compared to just 1.4% for advanced economies, according to the International Monetary Fund³. Part of this is driven by a shifting scope of capital that is being invested into resource-rich emerging markets.

Previously, less was being invested in EM where many of the companies that make tangible goods are situated. This is now changing due to an uptick in capital expenditure on the back of de-risking supply chains. We expect supply chain diversification to further bolster EM countries from increasing foreign direct investments and manufacturing, while supporting domestic earnings recovery.

3. Investors are relooking at fundamentals. EM corporate balance sheets have emerged stronger from the pandemic, reflecting their dominant positions within their national and regional (and even global) markets. In the past, investors ignored very good quality companies in EM both within equities and in fixed income due to their country of domicile. Credit ratings in EM are occasionally capped by the sovereign rating and belie the underlying fundamental strength of the issuer. Additionally, the events of yesteryear have led investors to shun the Chinese high yield space despite there being companies with resilient utility-like earnings, robust balance sheets, and diversified financing lines.

Investing in EM provides plenty of opportunities for investors looking to invest in stable, high quality companies at undemanding valuations. Indian bonds are a special case within EM where multiple stars are aligned: fundamentals are strong, inflation is coming down which leaves room for the central bank to start cutting rates, and the Indian rupee remains one of the least volatile currencies supported by a considerably small current account deficit and in excess of US$600 billion in reserves.

Assessing the risks

Investing in EM is never without risks. In our view, there are two factors that are currently dominating the conversations – China and the upcoming US elections in November 2024.

China’s sluggish reopening last year and a persistent weakness in the property sector soured investor sentiment towards EM. Our outlook for China, however, remains unchanged: we believe that a disconnect has emerged between market sentiment, as indicated by valuations and headlines, and what we see on the ground and hear firsthand from our companies, particularly in the equities space. While there are issues that China has to work through to get growth back up to speed, the reality is that it is still a massive country with the second-largest consumer base in the world. Household savings are at record levels, and a turn in sentiment could release a wave of incremental spending. At some point, pessimism for China will peak as it remains the cheapest major stock market in the world, cheap compared to history and at historic low when compared to the US.

Elsewhere, the outcome of the US elections would have implications for EM given trade connections. Our view is to take a wait-and-see approach, but also to invest in companies that can withstand whatever outcome occurs – that is, companies whose pathways to sustainable long term growth are not hamstrung by US policymaking. In this sense, EM corporates have gotten stronger over the last several years, and their access to financing have become more diverse, with many local financiers emerging in the market.

Conclusion

In summary, we believe that emerging markets can outperform developed markets in 2024 as many of the factors that have held back the asset class, including high interest rates, are gradually easing. From EM corporate debt to the Indian bond market to growth and income-generating stocks, the opportunities are spread far and wide across the asset class.