After delivering robust returns in US dollar terms last year, we believe there is a strong possibility for emerging market (EM) stocks and bonds to outperform developed economies in 2024.
Historical trends have shown that EM and Asia markets tend to outperform the US whenever the Federal Reserve (Fed) cuts rates. This is because, in addition to policy support, there is growth and earnings potential that are higher, more attractive valuations, and exposure to currencies that have higher carry – i.e., the return obtained from holding those currencies – relative to the US dollar in a rate-cutting cycle.
Three reasons why an outperformance is possible
Some of the crucial factors that have been holding back EMs are starting to abate:
1. Growing expectation for US interest rates to come down this year
Despite the US economy’s exceptional resilience last year, market expectations appear to be calibrating around a likely slowdown going forward. With fiscal policy having little legroom to support any deceleration in growth, considering the massive public debt saddling the American government, the Fed would likely be expected to do most of the heavy lifting by gradually lowering interest rates. When this happens, we would expect the US dollar to lose some of its strength in the market.
This bodes well for emerging economies, many of which have relatively high levels of US dollar-denominated debt. When rates are high, it puts constraints on their markets – although, EM countries now have more resilient current account positions and reserves that helped them avoid another taper tantrum when the Fed started raising interest rates.1 With inflation at target levels in many parts of EMs, several central banks have already undertaken monetary easing and are running ahead of the Fed.
2. Valuations in EM are at very attractive levels
EM equities are currently trading at 14.4x P/E versus 19x for developed markets (DMs), which implies there is scope for a significant rotation back to emerging markets.2 In fixed income, EM Investment Grade offers close to 50 bps spread premium over their DM counterparts, while EM high yield premium offers over 125 bps spread pickup for similarly rated DM peers. This is further supported by an encouraging growth outlook. Emerging economies are expected to grow at an average rate of 4% in 2024 compared to just 1.4% for advanced economies, according to the International Monetary Fund.3 Part of this is driven by a shifting scope of capital that is being invested into resource-rich emerging markets.
Previously, less was being invested in EMs where many of the companies that make tangible goods are situated. This is now changing due to an uptick in capital expenditure on the back of de-risking supply chains. We expect supply chain diversification to further bolster EM countries by increasing foreign direct investments and manufacturing while supporting domestic earnings recovery.
3. Investors are relooking at fundamentals
EM corporate balance sheets have emerged stronger from the pandemic, reflecting their dominant positions within their national and regional (and even global) markets. In the past, investors ignored very good quality companies in EMs both within equities and in fixed income due to their country of domicile.
Credit ratings in EMs are occasionally capped by the sovereign rating and belie the underlying fundamental strength of the issuer. Additionally, the events of yesteryear have led investors to shun the Chinese high yield space despite there being companies with resilient utility-like earnings, robust balance sheets, and diversified financing lines. Investing in EMs provides plenty of opportunities for investors looking to invest in stable, high-quality companies at undemanding valuations.
Navigating uncertainties
Despite all the opportunities present, investing in EMs is never without potential risks. In our view, two factors are currently dominating the conversations – first, China, which is the largest economy within the asset class, and second the upcoming US elections in November.
China
China’s slower-than-expected reopening last year and the persistent weakness in the property sector contributed to much of the negative investor sentiment around EMs. Our outlook for China, however, remains unchanged. We believe a disconnect has emerged between sentiment, as indicated by valuations and headlines, and what it is we see on the ground – particularly in the equities space.
While there are broader issues that China must work through, in terms of policies and getting growth back up to speed, the reality is still that it is a massive country with one of the largest consumer bases in the world. Household savings remain at record levels, and a turn in sentiment could release a wave of incremental spending. At some point, pessimism for China will peak as it remains the cheapest major stock market in the world, cheap compared to history and at a historic low when compared to the US.
US presidential elections
The other uncertainty facing EMs is the outcome of the US elections as there would be implications given trade connections. We believe in a wait-and-see approach, but also in investing in companies that can withstand whatever outcome occurs – that is, companies whose pathways to sustainable long-term growth are not hamstrung by US policymaking. In this sense, EM corporates have gotten stronger over the last several years, and their access to financing has become more diverse, with many local financiers emerging in the market.
Final thoughts
We believe EMs can outperform DMs in 2024 as many of the factors that have held back the asset class, including high interest rates, are gradually easing. The market consensus is for the Fed to lead global central banks on a rate-easing cycle sometime this year.
From EM corporate debt to the Indian bond market to growth and income-generating stocks, the opportunities are spread far and wide across the asset class.
1 The taper tantrum of 2013 refers to the wave of turbulence that spread through emerging markets after the Fed signaled it was about to tighten US monetary policy.
2 Bloomberg, 13 March 2024. EM equities refer to MSCI Emerging Markets Index. Developed markets refer to MSCI World Index.
3 "Real GDP growth." IMF Data mapper, March 2024. https://www.imf.org/external/datamapper/NGDP_RPCH@WEO/ADVEC/WEOWORLD/OEMDC.
Important information
Projections are offered as opinions and are not reflective of potential performance. Projections are not guaranteed, and actual events or results may differ materially.
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