The adage “it’s not about timing the market but about time in the market” has largely been right globally over the years. But try telling that to someone who started investing in emerging markets in 2008.
Since the end of the commodity super cycle, the economic growth premium – or differential – of emerging markets over developed markets has slowed.
Accommodative monetary policy has given rise to growth investing, with the large tech companies dominating returns. But the fact the MSCI Emerging Markets index has returned less than half the returns produced by global developed market equities (144% versus 329%) is stark to say the least.
Emerging market valuations are still extremely cheap
The past couple of years have been particularly challenging for the region as rising uncertainty in China, global inflation (especially in oil and food prices) and the strong US dollar have really hit performance. Covid-19 has also put extra pressure on manufacturing, a key driver of emerging market growth.
However, we did see some green shoots towards the end of 2022. The MSCI Emerging Markets index fell roughly 20% last year but did climb 10% in the last three months, with the re-opening in China, decelerating inflation, a weaker US dollar and improving fundamentals all playing their part.
Emerging market valuations are still extremely cheap on both absolute and relative terms – they’ve also been trading at a 35% discount to developed markets on price/earnings terms and at a 44% discount on price/book terms.
If there is to be a rebound, we must start with China, where attempts to tackle Covid and the troubled property sector, coupled with extremely attractive long-term valuations, are making the country an interesting investment prospect again.
Pent-up demand from the Chinese consumer should bring positives given they are sitting on record levels of savings
Although the re-opening process is unlikely to be smooth, it is a key development for emerging markets. Prior to the announcement, figures from Lazard show the market’s consensus for Chinese growth was 3.5–4% in 2023. The new relaxed measures are expected to raise estimates closer to 5%.
Federated Hermes Global Emerging Markets SMID Equity manager Kunjal Gala says the pent-up demand from the Chinese consumer should bring positives over the near term given they are sitting on record levels of savings.
He says: “I expect China to do well over the next 12 months but the stabilisation in the property sector and crackdown on other sectors, as well as wider geopolitical concerns, mean the region is likely to grow at a slower/sustainable rate of around 3-4% per annum over the longer-term.”
With many emerging markets being stretched to their limits by inflation, disinflation is on the agenda for 2023.
As rising interest rates meet this disinflation, improving real (or inflation-adjusted) interest rates will provide greater support for emerging currencies, which still look broadly cheap.
Inflation highlights the growing dispersion in the bloc’s fortunes on a country-by-country basis. Exporters like Indonesia and Malaysia were faring better than smaller commodity importers like Myanmar, Sri Lanka and Pakistan. China also stands out as almost being in a completely different cycle – cutting rates allows more room to respond to these pressures.
A softer US dollar should allow emerging market currencies to recover
Schroders head of emerging market equities Tom Wilson says disinflation should drive the US dollar lower as the currency’s real effective exchange rate (its value compared to a weighted average of several other currencies) is expensive versus history and may continue to soften if conviction rises that the Federal Reserve is moving successfully to re-anchor inflation and expectations have peaked.
He says a softer US dollar should allow emerging market currencies to recover, alleviating pressure on central banks and financial conditions.
Higher growth from China should manifest itself most clearly in rising commodity prices in the short term (having fallen back towards the back end of 2022). There will also be the long-term benefit of the move to decarbonise, which will put significant pressure on the production of certain commodities – copper for electrification, for example. The majority of these materials are found in a handful of emerging market countries.
The final point I’d like to make is that, while there have been many negative headlines about deglobalisation, the figures do not support this view.
Aubrey Global Emerging Markets Opportunities co-manager Rob Brewis says exports for all the major emerging markets have accelerated in recent years, with China leading, despite the recent global slowdown.
He says while there is a consensus that China is losing business, the latest American Chamber of Commerce survey from early 2022 revealed 83% of companies have no intention to relocate, unchanged from 2019.
He says: “There is inevitably some de-risking underway in global supply chains as manufacturers seek to diversify their production away from China, but this is all turning up in India, Vietnam, Mexico and Indonesia to name a few. In other words, it is very positive for most emerging markets.”
When you consider these reasons, coupled with attractive long-term trends (demographics, manufacturing capabilities, the abundance of critical metals and reforms/infrastructure investment) there is a compelling argument this is an attractive valuation point across the region.
You need look no further than China to understand there will be more bumps in the road but there is significant upside returns to be made for active managers from here. As well as the funds mentioned previously, investors may want to consider the likes of the FSSA Global Emerging Markets Focus or GQG Partners Emerging Markets Equity funds, or the JPM Emerging Markets trust.
Darius McDermott is managing director at FundCalibre
