Time to shine for Emerging markets?

As we progress into the second half of the year, US fiscal pressures are building, the dollar has materially pulled back and the outlook global growth is uncertain. Against this backdrop, portfolio manager Chris Tennant outlines why he believes now is the time for investors to revisit an asset class that has long been out of favour: emerging market equities.

We think that several structural and cyclical drivers are converging to make emerging market (EM) equities particularly attractive today. European equities have so far been the primary beneficiary of investors diversifying away from the US, but Ems are increasingly gaining attention. As research from HSBC shows, given the significant exposure of local investors in several EM markets to US equities, these domestic markets stand to benefit from any continued rotation out of the US.

Not only this, but in world where the fiscal pressures of developed markets, especially the US, are in focus, the relatively low levels of debt in many EMs appears attractive. In addition, many EM central banks raised rates early to contain inflation when it peaked in 2021-22, meaning policy rates are now high, giving scope to continue easing policy. Key metrics like current account balances and foreign exchange reserves are also generally stronger for many emerging economies vs a decade ago

Additionally, the US dollar has weakened significantly this year. A weaker US dollar is clearly positive for EMs, boosting purchasing power, lowering imported inflation and easing the burden of any dollar denominated debt.

While higher tariffs are typically viewed as a risk to EMs given their role as major exporters, this overlooks the declining reliance of EMs on exports to advanced economies, including the US, and the growing trade with other EMs. It is true that China faces the greatest impact from tariffs, but it is important to recognise that the Chinese equity market is largely domestic in nature and ongoing technological innovation means there's often limited alternative to Chinese manufactured products.

EM offers a growth premium at attractive valuations

The EM index trades at a price-to-book ratio of roughly 1.8x, a near 45% discount to the global index, the largest valuation gap seen in decades, despite the fact that EM offers an aggregate return on equity that is only around 20% lower than that of the global index. 

While much of this valuation discount has been driven by weak sentiment towards China, we are seeing stimulus coming through and green shoots emerging in key sectors like property. Given China’s heft in the EM index, any further recovery here will be a significant boost for the broader universe.

Although China’s growth prospects are more subdued versus history, other EMs are stepping up. Market consensus expects EM to deliver earnings growth of around 14% over the next 12 months, compared with around 10% for developed markets. Key drivers include technological innovation in markets like Taiwan, and favourable demographics in India, Indonesia and Vietnam. With the global macro backdrop looking shaky, the growth premium offered by EMs vs DMs looks increasingly appealing.

Three high conviction sectors

Emerging markets continue to offer a diverse range of opportunities, particularly in areas where structural growth trends intersect with attractive valuations. We currently see particular value in three key sectors: consumer discretionary, financials, and materials.

In consumer discretionary, we’ve maintained significant exposure to China. Early signs of recovery in the property sector - particularly in tier-one and tier-two cities - are expected to support a rebound in consumption. This should benefit holdings such as Bosideng, a Shanghai-based down apparel manufacturer, which is well-positioned to capture rising domestic demand.

The portfolio’s overweight to financials is expressed through a diverse range of companies operating in the sector. On the one hand, we own Indian banks, which gives us exposure to the country’s demographic trends without the extreme valuations prevalent in the domestic consumer sector. Elsewhere, we also favour selected fintechs such as e-commerce and payments platform Kaspi, as well as central and eastern European banks like OTP Bank. These positions provide a balance of growth potential and reasonable valuations.

In materials, we’re focused on gold and copper miners. Gold equities have significantly lagged the underlying commodity price despite many miners generating free cash flow yields above 20% at spot prices. This disconnect presents a compelling opportunity, particularly in names like Buenaventura, which has recently upgraded guidance and delivered strong results but continues to underperform the broader Peruvian market.

Geographic positioning

From a geographic perspective, we have established an overweight position in Indonesia, which offers similar demographic advantages to India but at substantially more attractive valuations; and Mexico, which is positioned to benefit from near-shoring trends and, at the start of 2025, was trading at valuation levels not seen in over 15 years. Many listed companies derive the majority of their earnings from the US yet remain deeply discounted due to their local listing - creating a disconnect we believe offers significant upside.

Brazil also stands out as one of the most undervalued markets globally, trading at just 8x earnings. While fiscal concerns remain, the economy is strong, unemployment is at multi-decade lows, and upcoming elections could catalyse a shift toward more market-friendly policy.

Conversely, we are more conservatively positioned in India and Taiwan. While both markets offer strong structural growth characteristics, current valuations are elevated and we are happy to wait for more attractive entry points to emerge.

While the case for emerging markets is strong, investors should remain mindful of risks. While EMs have reduced their reliance on the US as a source of exports, the global trade environment remains unpredictable. Geopolitical tensions continue to drive volatility, and any significant global economic contraction would likely pressure emerging market equities.

Our focus remains on identifying opportunities within the emerging market universe, where overlooked sectors and countries present the potential for attractive shareholder returns. With compelling EM valuations compared to developed markets, particularly the US, we see clear prospects. However, discipline is critical, as not all markets and not all sectors and regions are or will remain cheap, making an active approach vital.