The price is right: the case for emerging markets

Last week the Federal Reserve surprised markets. Not so much by taking rates to 3.75%–4% – the quarter-point hike was by then widely expected – but because the decision, taken by a Committee split between "orthodox" members and "loyalists", was unanimous.

The united vote, including that of newly appointed Chair Kevin Warsh, reinforced the perception of a central bank determined to fight rising prices, driven largely by the cost of energy commodities. The communication style was also different but, all things considered, consistent with what Warsh had signalled at Jackson Hole: few words, few promises, plenty of flexibility. For Warsh, a data-anchored reaction function is preferable to forward guidance. The style recalls Paul Volcker, the Fed chair who went down in economic history for defeating the runaway inflation of the early 1980s. He applied unprecedented monetary shock therapy while maintaining deliberate opacity – for Volcker, communication was not a monetary policy tool but a potential source of disruption: he took rates to 20% without any advance warning.

Warsh left the door open to further moves: US growth is holding up and the labour market is robust, but prices remain under pressure because of energy costs. Markets regained confidence in the Fed's resolve to control inflation over the long term. Having broken through the psychological 5% threshold – levels last seen in 2007 – the 10-year Treasury yield eased back to around 4.95% after the announcement, the dollar strengthened and gold reversed sharply, losing more than 1%.

Investors are grappling with a scenario in which, on the one hand, politics has failed to ease tensions in the Gulf, oil prices remain high and inflation expectations are equally elevated; on the other, higher-for-longer rates end up weakening growth and consumption.

Why diversification matters again

The prospect of further hikes points to greater data sensitivity and higher volatility. In an economic environment dominated by uncertainty, the investor's anchor lies in staying true to method. With equity performance increasingly concentrated in large US technology companies, geographic diversification is back on the agenda – and specifically, exposure to emerging economies. Not so much in search of greater risk and returns, but to invest in economies following different trajectories from those of developed countries.

There are at least three reasons to look closely at emerging economies:

1. A different point in the monetary cycle. Many emerging market central banks tackled inflation ahead of the Fed or the ECB and have already completed the most severe phase of tightening. Some now have room to support growth that advanced economies have yet to regain.
2. Valuations. The price is right: after years in which most global flows went to the United States, many emerging markets trade at lower multiples than developed markets. This is worth attention for those setting portfolio allocation with a long-term view.
3. Reducing dependence on a single narrative. This is perhaps the most important reason. A growing share of global equity performance now depends on a handful of large companies linked to artificial intelligence. Emerging markets offer exposure to domestic consumption, infrastructure, credit, advanced manufacturing and domestic digitalisation.

Demand from US hyperscalers is strengthening confidence across the entire AI supply chain in emerging economies.

Demographics and ESG as structural drivers

Then, of course, there is the structural component of demographics. In many countries of Southeast Asia and other emerging regions, millions of people are strengthening the middle class, moving to cities and gaining access to education, increasingly skilled jobs, healthcare and more diversified consumption. It is slow progress, less visible than the much-vaunted wonders of the technological revolution, but no less powerful.

Historically, emerging markets have been associated with volatility and governance risks. Integrating ESG (environmental, social and governance) criteria can help mitigate those risks: selecting companies with high governance standards excludes inefficient companies, opaque businesses and firms exposed to environmental and reputational risks. Then there are flows: large global institutional investors are increasingly directing their allocations towards assets that comply with sustainability regulations. Buying sustainable emerging market companies today means gaining exposure to stocks that stand to benefit from steady demand in the near future.

The thorns: dollar, geopolitics and liquidity

Naturally, there are thorns. A stronger dollar can put pressure on many emerging economies. Geopolitical tensions hit hardest those countries most dependent on imported energy and international trade. A more aggressive Federal Reserve could also drain liquidity from global markets in the short term.

But this is precisely where the case for diversification and active management emerges: not the search for the next winner, but the construction of portfolios able to draw on different sources of risk.

Anne Brontë wrote that he who dares not grasp the thorn should never crave the rose. In emerging markets the thorns are clearly visible, yet the roses keep blooming – even far from Wall Street.