Outlook 2024: Tim Love (Emerging Market Equities)

Emerging Market Equities – Perceptions are way behind reality; the opportunity cost of missing a rally could be high

December 2023

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Emerging market (EM) equities are still under-loved, under-owned and undervalued, in our view – more so than at any time in the past decade. We believe that all they lack is a “risk on” catalyst to release their inherently attractive upside returns and for investors to appreciate the more limited downside characteristics of the asset class. In short, to take the view that EM offer an enviable risk/return quadrant.

As international markets oscillate between ‘Goldilocks’ and ‘higher-for-longer’ sentiment, local domestic flows are growing meaningfully in India, China and Taiwan. This adds to the heady risk of a decade-long break out to the upside and a material risk of not being in EM equities when they finally turn.

What could the missing catalyst be?

There are a number of potential catalysts, including the US dollar and US Treasury yields peaking, post the US Dollar Index reaching 26-year highs. Both these would be very supportive for EM equities, especially EM value stocks. We believe EM equities are at a rare point in a multi-decade perspective, exhibiting highly attractive cyclical entry points, as well as considerable secular support – in our view, a confluence of events that is as powerful as it is rare. Cheap cross-asset EM equity valuations with large demographic dividends and GDP per capita gains (especially India) is a powerful tailwind. Even if global economic growth underwhelms, then EM equities are unlikely to meaningfully underperform the developed world, in our view. We believe that they are, however, likely to exhibit good relative upside performance in USD.

Drivers of EM equities include a multitude of factors. Cyclical and valuation supports include higher GDP and corporate top-line growth compared to developed markets (DM), as well as lower ‘growth at a reasonable price’ valuations with an accompanying EM yield attraction. EM equities should appeal to value, growth and yield investors, in our view.

EM equities have evolved

The asset class bears little resemblance to the old EM Index from a decade or more ago. In 2004 the index had only four investment grade (IG)-ranked countries in the top 11 country constituents – now that has risen to nine of the 11 top markets. Furthermore, EM debt and debt service dynamics, at both sovereign and corporate levels, are materially lower than DM economies. EM countries mainly avoided the quantitative easing decade of negative real rates and, instead, still have high ‘positive carry trades’, despite their central banks noting lower consumer and producer price inflation falls than that of nominal rates. And the two non-IG countries, South Africa and Brazil, have been relatively stable currencies, despite this choppy change in world GDP expectations.

The inclusion of centres of excellence in robotics/artificial intelligence (Korea/China), electric vehicles (EV) (China), global consulting (India), EV materials (South African platinum, Latin American (LatAm) lithium/copper, Malaysian rare earth minerals) and on-shoring high end industrialisation parks in Poland/Mexico and Vietnam/Romania, are all major foreign direct investment and earnings per share (EPS) sources for EM nations. These are not the same as agricultural and low value add end export economies of the 90s. This higher resiliency and quality facilitate a greater stability of EPS and a higher target for multiple expansion as and when it occurs.

The domestic demand in India is massive – see the number of new bank accounts in the past decade (greater than EU in total). Add on the China economy’s scope to benefit from fiscal stimulus, and it leads to a long list of positive structural challenges. Note, in the short term, a ‘command economy’ like China can address economic challenges more directly from a coordinated state level.

The risk of being out versus in

EM equities are not far from their all-time low valuations and stock price levels, while the opposite applies in DM equities. 2010-2023 compares to a lost decade in EM equities in the Asian Crises and SARS years in 1994-2004, prior to its subsequent massive re-rating.

A possible taster of a catalyst was the impact of the evidence of lower cost of capital in late October/early November 2023. Equities rallied, bond yields fell, and the US dollar depreciated after the release of data showing cooler US headline and core inflation in October. The weaker-than-expected data bolstered hopes that the Federal Reserve’s rate hiking cycle is over and that rates could be cut in 2024. In this environment, we expect EM equities to meaningfully keep outperforming cross-asset alternatives, as well as other DM equities.

The risk is clearly to being ‘out’ versus being ‘in’, but, in our view, EM equities are still being wrongly perceived as still supported by the EM EPS stream of the past. We believe perceptions are way behind reality. Nothing increases awareness quite as much as the fear of missing a rally when the opportunity costs of doing so could be high. Then we think awareness of the real merits of the asset class will shine though.

In our view, it seems EM equities are wrongly named, wrongly priced and fully misunderstood. We believe that a decent PER multiple re-rating will soon bring animal spirits back to the fore, as in 2004-08. We think this time could be equally breathtaking.