A turning point for emerging market equities?

After a decade of relative weakness for emerging market equities, investors are starting to ask whether the tide may be turning for the asset class. Against an improving backdrop of likely-peaking interest rates, nascent improvement in China, and higher commodity prices, we examine the current dynamics and tailwinds that are driving renewed interest in emerging markets equities.

Emerging markets (EM) have been out of favour over the last decade. Over the 15-years the team has been managing the Global Emerging Markets portfolio, the emerging market index has broadly remained flat. Weakness in China and concerns around geopolitics explain part of this, while the strong outperformance of US equities relative to EM, and a strong dollar have also been headwinds for the asset class. As a result, EM as an asset class is relatively unloved - with the index trading at the cheapest level in 20 years, relative to developed markets. Given that current valuations are looking increasingly attractive, and with many of these headwinds now reversing, we think now is an opportune time to revisit the asset class.

Peaking rates and an improved fundamental backdrop

Two factors that have will have a significant influence on the outlook for EM for the rest of 2024 are whether the US will be able to deliver a soft landing and the pace of China’s economic recovery. Linked to the first factor, is the timing and pace of the Fed’s interest rate cuts.

What we’ve seen during the current global rate hiking cycle is a considerable change from previous episodes of high inflation. While previously many emerging market central banks have battled with periods of hyperinflation and a lack of central bank credibility, during this cycle, a number of emerging market central banks were actually much more decisive in raising rates quickly - and indeed well ahead of the Fed - to increase rates and bring inflation under control.

Brazil for example is a good illustrative example where the central bank quickly hiked interest rates to 13.75%, bringing inflation down from 12% in 2022 to under 4% currently. As a result, Brazil was one of the first central banks globally to be able to start cutting interest rates last August from close to 14% to 10% today.

We broadly see disinflation across many markets, and central banks have been able to successfully anchor inflation expectations and act with credibility. As a result, we see high real rates in many economies such as Brazil and Mexico, which means there is still significant scope for rates to come down once the Fed moves to ease policy. This will have a positive impact on consumer demand, the backdrop for corporates, and should help drive flows to equity markets.

High real rates in Brazil and Mexico mean still scope to cut

Source: Fidelity International, Bloomberg, 17 June 2024.

Signs of stabilisation in China

Meanwhile, signs of stabilisation in China’s economy have led to improved investor sentiment. Weakness in China over the last few years has weighed on emerging markets, with the struggling property market - which makes up 30% of GDP - having a significant impact on consumer confidence. Property prices continue to fall, and while the recovery will likely be slow and protracted, it appears the sector may be past the worst.

A key feature of the market in 2023 was the underperformance of the Hong Kong market relative to the domestic A share onshore market, with foreign investors - who typically access the market via the Hong Kong exchange - exiting the region. We have seen this trend reverse in 2024, as H shares (traded on Hong Kong's stock exchange) outperform A shares (traded on Mainland China’s stock exchanges), largely driven by foreign investors looking to re-enter the market.

While growth in China will likely remain more muted than it has been historically, in this environment we are seeing other positive developments come to light. For example, the growing prevalence of companies returning capital to shareholders via mechanisms such as buybacks is helping underpin shareholder returns. This is particularly effective when valuations are depressed and can create significant value for minority shareholders.

An example of a business doing just this is VIPshop, an online flash sales retailer in China. Although VIPshop has been vulnerable to weaker consumption trends, one way through which the company has been supporting its share price has been through its generous buyback and dividend policy. This is a company whose current market cap is $8.2bn, and in 2023 it carried out a $700m share buyback and $250m dividend payout - equating to over 10% of its market cap. In an environment where multiples have derated and consumption trends have been so weak, this level of cash return has been an important means of providing downside protection for the stock.

Higher commodity prices provide a tailwind

A significant factor that is supporting the improved fundamental backdrop for emerging economies is the buoyant commodity price environment. Commodity prices are a key driver for economies such as South Africa, Mexico, and Brazil, supporting their exports, foreign exchange reserves, and current account balances. Commodity prices have risen this year off the back of broad-based economic momentum. However, there does remain dispersion within commodities. For example, there is a more muted backdrop for iron ore due to weakness in the China property market while, by contrast, there is a much more positive outlook for copper.

Known as “doctor copper”, the metal is benefiting from improved global economic momentum. But we also see some very specific demand/supply dynamics for the metal. We believe there is a strong demand outlook given that copper is a vital input for electrification and datacentre servers. At the same time there is an extremely challenged backdrop for supply - there are very few copper mines in operation, and those that do exist have declining grade quality, with miners having to dig deeper for the metal. 

Ivanhoe Mines is an example of a company benefiting from this outlook for copper prices. The Canadian listed company operates low-cost copper mines in emerging markets, primarily in the Democratic Republic of Congo (DRC), that exhibit high production growth. It also benefits from its copper exploration project in the DRC’s western forelands - representing a potential asset that could be in high demand given the backdrop of limited copper supply coming online.

An attractive entry point

With positive macroeconomic tailwinds, a more robust commodity price environment, and an improved fiscal backdrop, there are several positive short and medium-term drivers for emerging market equities, in addition to the long-term drivers of positive demographics and rising middle class wealth. 

On a price to book basis, the emerging market index relative to the global index is still trading at a deep discount to developed markets. Given that emerging market equities have underperformed over more than a decade now, valuations are very attractive and appear out of sync with what we think is an increasingly positive fundamental backdrop for many companies.