After losing 4% by mid-January[1] – their worst new year start since 2016 – developing world equities have since recovered, boosted by positive policy initiatives in key markets. With EM equity fund inflows hitting a record weekly high at the start of February, we revisit the investment case for EM equities and why they can still have an important role to play in a diversified portfolio[2].
Long-term economic growth
The factors driving structural growth across many emerging markets remain strong. Increasing urbanisation, education and income levels are creating a rising number of middle-classes with significant spending power, while advancing technology is helping to boost productivity and output among developing nations.
Emerging markets’ share of global GDP has grown from around a third to over half since the turn of the century (fig.1). Much of this expansion has been driven by trade between EM countries with huge growth in both dollar terms and as a percentage of global exports over the same period (fig. 2). These powerful trends will continue and although the correlation between economic growth and equity performance is non-linear, they help to create attractive investment opportunities in areas ranging from technology, consumer and healthcare to infrastructure and energy.
Cyclical macro and market tailwinds
The latest IMF Global Economic Outlook forecasts EM real GDP growth of 4.1% this year and 4.2% next – more than double that of advanced economies (fig. 3). Output is expected to be particularly strong in Asia, where economies are predicted to grow more than five times faster than Europe in 2024.
EM equities have historically performed strongly once the US starts cutting interest rates and the dollar weakens, and while the Fed easing has likely been delayed as inflation proves sticky, it is still anticipated this year. Indeed, previous periods of persistent inflation like the 1970s have seen EM equities outperform other assets, followed by value stocks (fig. 4).
Superior earnings growth
Driving much of EM’s superior output will be its fast-growing companies. Corporate earnings are expected to strongly rebound in 2024 with year-on-year growth of around 18%, nearly double the US and almost four times higher than Europe (fig. 5). Much of this is expected to come from Korea, where EPS is forecast to grow over 50% this year, driven by a cyclical recovery in its semiconductor industry and a range of government measures aimed at improving profitability and corporate governance.
Longer-term, many EM companies are leading the global technology revolution in AI, electric vehicles, e-commerce and mobile payments, which should support sustained earnings growth. The rise of nearshoring, where supply chains are localised to manage risks and costs, is also supportive for EM earnings, particularly for companies situated in powerful economic hubs like Southeast Asia and Latin America. Alongside, friendshoring (sourcing from countries that are geopolitical allies), this could be an important medium-term factor of economic and earnings growth.
China recovery
2023 was particularly disappointing for investors in China with equities weighed down by geopolitical tensions and a real estate implosion as the country struggled to recover from COVID-19. With the MSCI China index losing almost half its value in the last three years, the earnings multiple of Chinese equities currently sits at the bottom of its range since 1990 (fig. 6) and at a record 60% discount to US equities (fig. 7).
The current Chinese Equity Risk Premium[3] of almost 10% has only previously been higher during the 2008 Global Financial Crisis and similar levels have historically been followed by positive 12-month forward returns. These could be further boosted this time round by the Chinese government recently cutting bank reserve limits to boost lending and tightening short selling rules, as well as a proposed $278bn rescue package to stabilise equity markets.
Compelling valuations
Company price tags across emerging markets are highly attractive, relative to historic averages as well as developed markets, where the increasing weight of US technology stocks creates unprecedented concentration. For EM value equities, which currently trade more than 50% below EM growth stocks, prices are particularly compelling.
While low valuations are a necessary condition for positive long-term returns, so are catalysts for re-pricing and three key themes could unlock significant value this year in countries that represent nearly half (45%) of the EM universe (fig. 8). Alongside supportive policy measures, the favourable economic, market, company and valuation factors mean the case for emerging market equities look favourable to those inclined to take a contrarian position.
Watch our latest emerging market update from SKAGEN Kon-Tiki.
NB: All information as at 31/01/24 unless stated.
[1] MSCI EM Index in EUR as at 19/01/2024.
[2] Source: EPFR, week ending 07/02/2024.
[3] 12-month forward earnings yield less 10-year nominal government bond yield.