Why is it a good time to invest in emerging equities?

In the current financial environment, emerging equities present themselves as an attractive option for investors. Four fund management experts offer their perspectives on why now might be a good time to venture into this type of asset. Their analyses provide crucial insight for those seeking to capitalise on the potential of expanding markets.

Raheel Altaf, Global Emerging Markets Manager, Artemis

It will come as no surprise to learn that we fervently support emerging markets. We think they offer valuable diversification for most investors. And the long-term prospects for many emerging economies, in terms of growth, demographics, and consumer demand, are compelling. So when emerging market equities started 2023 with a strong rally, driven by optimism about China's post-pandemic reopening, we thought their gains were richly deserved. Unfortunately, January's rally was short-lived: despite the initial premise, emerging market equities have again underperformed their developed market peers this year.

Is this underperformance justified? And, if not, what catalysts could encourage a change? The long-term case for emerging markets is well known. But why should you look at them now?

• China announced substantial policy support One of the main reasons why emerging markets posted such disappointing returns this year was the disappointing news from China. While the Chinese economy grew at a healthy pace in the first quarter (up 2.2% from the previous quarter), growth slowed to only 0.8% (on a quarterly basis) in the second quarter. It is attributed to weak domestic demand and difficulties in the real estate sector that this growth fell so far short of expectations. This weakness seemed to be confirmed in July, when China reported worse-than-expected data for both imports and exports. However, the important point is this: policymakers in Beijing are not sitting back while their economy struggles. The news that consumer prices had fallen into deflation was enough to convince them to take more direct measures to support demand. An unexpected cut in one-year interest rates in mid-August could prove to be the start of more substantial policy actions. And while hopes that China will use a 'bazooka' stimulus may be a little optimistic, we expect continued measured accommodation for the rest of this year.
• Emerging markets are starting to enjoy a more favourable interest rate environment (as well as stronger economic growth) Look beyond China, meanwhile, and the path taken by monetary policy in other emerging markets is increasingly diverging from the developed world. Chile led the way with rate cuts in July. Brazil - where consumer inflation has fallen from 12% to just over 3%1- followed suit in early August, cutting the Selic rate and indicating that further cuts will follow. In terms of GDP growth, on the other hand, emerging market economies are expected, on average, to grow by 4.0% this year and 4.1% in 2024. Although this is below their long-term average, it is well above the developed economies, where growth is expected to be only 1.5% this year and 1.4% next year.
• Valuations: emerging markets are now trading at multi-decade lows against US equities. Another possible catalyst for change is the large disparity in relative valuations. Looking at cyclically adjusted valuation multiples, emerging market equities are now trading at multi-decade lows relative to their US peers. And as macroeconomic concerns ease, we believe investors will begin to reflect on relative valuations.

When they do, we suspect they will find the valuation story in emerging markets compelling. We use a systematic process to screen the global stock market for companies whose growth potential is currently undervalued. For some time now, that process has been giving us a clear signal: value stocks in emerging markets offer one of the best value ratios of all equity markets in the world. This, in our view, provides useful downside protection.

The cyclically adjusted Shiller p/e ratio suggests that emerging markets are attractively valued relative to their global peers.

Source: Bloomberg, 31 July 2023. The indices are MSCI for EM, Asia ex-Japan, UK and Europe, S&P 500 for the US and TOPIX for Japan.

Rubén Ruiz, Lead Portfolio Manager & Fund Selector, CaixaBank AM

Currently, CaixaBank Asset Management's view on emerging markets is close to neutral and has improved over the year. Although emerging markets comprise much more than China, the Asian giant has a significant weight globally and the downward revisions to its growth after the (failed) reopening together with the problems in the real estate sector have not been welcomed by investors and have implications in other markets.

China's growth in recent decades has relied heavily on real estate and infrastructure development underpinned by its large population and significant migration from rural to urban areas. These demographic dynamics are changing and demand for housing is expected to decline in the coming years, affecting the Asian giant's growth as it gradually tries to shift its growth towards consumer and innovation-related sectors.

Nevertheless, there is light at the end of the tunnel and we should not forget the important weight of China's industrial and manufacturing sector, which together with low inventory levels in general and attractive valuations could trigger positive dynamics for stock markets and the economy. The fear of a recession in the US has depleted inventories as companies have been very cautious in managing their inventories and the divergence between orders and inventories is high [Chart of US orders and inventories] the correction of this imbalance could be beneficial for some emerging markets, in particular for the Asian giant.

Evolution of Durable Goods Stocks and Orders

Furthermore, a rebound in Chinese activity could have a positive impact on more distant regions, such as Latin America, due to some increase in demand for raw materials. Despite their internal dynamics, emerging countries are also influenced by events in developed countries, and the current cycle of high inflation, rising interest rates, and currency movements directly affects developing economies and their debt payments. While it is true that the effect of inflation is global and also affects emerging economies, these countries are more accustomed to and in some cases have more flexibility given their higher growth figures.

In summary, our view is neutral on emerging equity markets, slightly more constructive than in recent months, with a focus on China and a focus on its problems in the real estate sector and the measures the government might put in place to stimulate growth. In other regions, such as Latin America, if there is some increase in industrial activity, we could see progress in the commodities market, which could give some impetus to the region's stock markets in particular and emerging markets in general.

Paulo Salazar, Head of Emerging Markets Equities, Candriam

Dominating the ever-changing landscape of global finance and technology is Artificial Intelligence (AI), a revolutionary force that is reshaping industries, economies, and societies. It is precisely in emerging markets (EM) that one can find the companies and regions ready to lead this transformation.

Consider, for example, smartphones, such as the iPhone. These devices have conquered the world and many of their components are produced in Asia. Similarly, in the field of artificial intelligence, hardware manufacturers and designers in emerging markets play a key role. These companies are the backbone of AI and build the foundations for its applications.

In today's technology landscape, the importance of semiconductors goes beyond mere hardware components. One could speak of a 'modern gold rush', where the gold is now represented by the rich opportunities found by companies involved in manufacturing and supplying semiconductors for AI applications. The strategic importance of these semiconductors in the age of Artificial Intelligence cannot be overestimated. As AI continues its inexorable advance, infiltrating various sectors, the demand for high-performance, energy-efficient semiconductors will increase, turning them into the digital goldmines of our time.

Emerging stock market returns have been disappointing in recent years and have led some to overlook the potential of these markets. However, therein lies the opportunity. EMs are currently unloved, under-owned and under-appreciated by investors, which can create an advantageous entry point for those willing to explore these markets.

In 2022, global equities saw a major shift, with a rotation towards sectors that had previously lagged behind due to rising inflation and external shocks. However, it is important to remember that past performance is not always indicative of future results. The real growth lies in emerging markets, where low valuations compared to developed markets (DM) are attractive. China, despite current challenges, is a leader in high-tech sectors destined for continued growth, such as artificial intelligence, electric vehicles, and advanced manufacturing.

Investors should approach China and other emerging countries with caution and responsibility. High environmental, social, and governance (ESG) standards should guide investment decisions. Although the Chinese market presents uncertainties, transparency issues, and forecasting difficulties, the potential for long-term growth and profits remains significant.

We prefer to take a thematic approach to investing, focusing on identifying long-term trends and leading companies in their respective sectors, as well as sectors that benefit from policy support, such as electric vehicles (EVs) and green energy. The ever-changing nature of emerging markets underlines the need for an active approach to investing in these markets.

Artificial intelligence is the force that is reshaping our world and emerging markets are at the forefront of this revolution. From hardware manufacturers to semiconductor suppliers, they all offer a unique opportunity for investors willing to embrace the potential of AI in emerging markets. The AI revolution is upon us and it is time to seize it with care, foresight, and a keen eye for the opportunities ahead.

Daire Dunne, equity manager, Wellington Management

Emerging market stocks are trading near historic lows, but investor enthusiasm for this asset class is tempered by a number of factors, including concerns about escalating geopolitical tensions between China and the US and China's post-Covid recovery, which has been weaker than expected.

Nevertheless, we believe there are a number of strengths that could cushion investors' concerns. Although the US and China appear to be in a state of permanent trade war, some progress is being made on the sidelines. First, we are encouraged by the re-establishment of channels of communication between the two sides: US Secretary of State Antony Blinken's visit to China in June, the first major one since former Secretary of State Mike Pompeo's trip in 2018, was quickly followed by another 'constructive' visit by Treasury Secretary Janet Yellen in early July. Secondly, news on the corporate front is steadily improving: for example, on 5 July Moderna signed a memorandum of understanding and territorial collaboration agreement for the production of mRNA-based drugs in China.

As for growth, given the lower inflation in emerging markets compared to developed markets, most emerging economies, including China, continue to grow at or above the long-term trend. While the economies of developed countries had the luxury of being able to stimulate their economies during the Covid, this 'helicopter money' maneuver was incompatible with the budgets of emerging countries, which therefore followed a more moderate stimulus policy. This fiscal expansion proved to be extremely inflationary for developed countries while emerging countries were spared the resulting inflationary pressures. Now, positive real interest rates in emerging countries should allow for more flexibility in monetary policy at a time when recession fears are the order of the day for policymakers in developed countries.

Source: Haver analytics, data as of May 2023.

When investing in the structural growth dynamics of emerging economies, one is also less tied to "market timing". We believe that, from a structural perspective, the emerging universe offers an attractive alpha-generating opportunity for long-term-oriented investors. By investing in specific themes, investors can reduce sensitivity to the business cycle and gain downside protection, which is particularly important as the new macroeconomic regime could bring increased volatility and sharper cycles. Given the significant economic and market changes over the past decade, it may be time to rethink emerging market equity exposures and position investments to benefit from structural changes.

Why now? Negative sentiment and underperformance have held backflows for more than a decade, but emerging market volatility has declined significantly over this period: the gap between emerging and developed market volatility has narrowed significantly and the correlation between the two is at an all-time low (0.76 in August 2023 versus 0.89 in December 2010, source: Wellington Management). Emerging countries face less cyclical pressure on inflation than developed countries due to lower labor shortages, their positive real interest rates allow for more monetary flexibility, and equity markets and currencies have now reached very attractive valuations. We believe that the policy focus in emerging countries (and the rest of the world) is shifting towards a more inclusive, innovative, and sustainable economic environment.