Emerging market equities: Stars aligning for a change of fortune?

10 min read 16 Aug 23

Investor sentiment towards emerging market (EM) equities has been lacklustre for several years now and they have lagged developed market stocks, particularly the US market. However, we believe that this cycle of underperformance might be nearing an end and the fortunes of EM equities could recover. With improving fundamentals, better corporate behaviour and attractive relative valuations, in our view, the outlook for EM is promising.

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance. The views expressed in this document should not be taken as a recommendation, advice or forecast. 

Investor sentiment towards EM equities has been lacklustre for some time now. When we look back at the relative performance of EM over recent decades, we observe a pattern of alternating fortunes. There have been periods of significant outperformance against the US and global equities. On the other hand, the past ten years have proved challenging (figure 1). 

However, we strongly believe that the current cycle of underperformance could be coming to an end and the tide could well turn back towards EM. In our view, the dynamics that could fuel this re-evaluation are already well underway and are becoming better understood by investors. We offer our reasons for this potential change of fortunes below.

Reason #1 Change in corporate behaviour

Recent years have been a painful time for EM investors as returns have been poor and they have underperformed developed markets, especially US equities. Part of the reason investors have stayed away from the asset class has been to do with profitability, which has been erratic and generally weak.

Figure 1: Changing fortunes: EM underperformance coming to an end? 

MSCI EM v S&P 500 (1987 – 2023)
Past performance is not a guide to future performance

Source: Refinitiv Datastream, MSCI, S&P, July 2023. Rebased to 100 31 December 1987.

Investing in emerging markets involves a greater risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks, among other factors. There may be difficulties in buying, selling, safekeeping or valuing investments in such countries.

Return on equity (ROE) at EM firms has been about half that of the US, where tech giants have delivered significant returns.

However, looking ahead, we anticipate a shift in that return profile. In the past, EM companies were focused on growth and many overinvested, destroying capital on unprofitable ventures. We are now observing a change in behaviour, by state-owned companies, conglomerates and private firms. Companies are showing much greater capital discipline when committing to new projects. They are also increasingly focused on delivering returns to shareholders in the form of dividends and share buy backs. 

We are encouraged by this improvement in capital allocation and balance sheet behaviour and remain optimistic that it can help EM equities close the gap with developed market stocks.

Reason #2 Currency weakness – not this time

Emerging markets have typically been vulnerable to US rate cycles. In the past, we have seen money flow out of the asset class, typically to the US, causing sharp dislocations in emerging market asset prices.

But in 2022, and so far in 2023, it feels very different. We haven’t seen the same sharp dislocation because emerging markets are arguably in a better position to cope with US rate hikes. We have seen some currency weakness, but in Asia this has been related partly to concerns about China and, in the case of South Korea, a potential slowdown in global growth.

Interestingly, Latin American currencies have been among the best performers in this period (figure 2). This is because central banks in the region had to react swiftly to the prospect of inflation being passed through to their economies from the COVID-related stimulus being introduced in the West.

As a result, many countries hiked rates aggressively, and although this meant their economies slowed down, it ensured their currencies have remained resilient, which is in stark contrast to previous rate-hiking episodes. They are benefiting now as inflation is abating, enabling central banks to consider cutting rates, ahead of their developed market counterparts. In fact, the rate cycle in EM appears to be turning already, led by Chile where the central bank cut rates in July.

Figure 2: Currency divergence

Performance of EM currencies vs US dollar (2022 and YTD 2023)
Past performance is not a guide to future performance

Source: Refinitiv Datastream, 19 July 2023. 

Reason #3 Improving fundamentals 

Alongside a more favourable macroeconomic environment, we are observing encouraging trends at the micro, or company, level which could benefit emerging market equities. A source of disappointment for investors in recent years has been the earnings picture. We have seen company earnings fall dramatically twice in the past decade, before recovering.

However, over the course of 2022 profitability trends (as measured by ROE) stabilized quickly and perhaps more rapidly than investors and commentators expected (figure 3). We believe this is driven partly by a change in corporate behaviour. Emerging market firms have realised the days of easy growth are over and, in our opinion, are, by and large, becoming more professional and starting to understand the importance of using capital efficiently.

Figure 3: EM opportunity: sustainably higher returns?

Return on equity (ROE) MSCI EM (%)
Past performance is not a guide to future performance

Source: Morgan Stanley, Refinitiv Datastream, June 2023

We think capital discipline has improved: companies are investing more sensibly to generate returns on capital. They are also becoming more shareholder friendly: firms are distributing more capital to shareholders. This is evidenced in part by the highest dividend yield that has been on offer from the MSCI EM Index for more than a decade.

In our view, these positive developments are not fully understood and support a more optimistic outlook for the asset class.

Reason #4 Undemanding valuations for a diverse range of opportunities

On pretty much any metric we look at EM equities are cheap in relative terms compared to global and US equities (figure 4). In our opinion, this suggests that investors’ negative sentiment is overshadowing some of the positive trends we observe in EM today.

Investors often focus on China as the dominant market in EM, but we believe there are also many interesting opportunities elsewhere. It is important to remember that EM equities are not a homogeneous asset class – they comprise many distinctive economies, with different drivers and features. And that is before you consider the enormous spectrum of companies that can be found across the entire global investment universe.

Figure 4: EM opportunity: attractive valuations

12m Forward price-to-earnings (P/E) ratio MSCI EM
Past performance is not a guide to future performance 

Source: Morgan Stanley, Refinitiv Datastream, June 2023

In Asia, markets like South Korea and Taiwan have some correlation with global growth and the technology cycle. As a result, they are fairly volatile at the moment. The ASEAN region has different characteristics and looks interesting to us now – markets like Vietnam and Malaysia are benefiting from companies moving their supply chains away from China, while Indonesia is a large commodity producing nation, with favourable demographics that could boost economic growth.

Mexico is also benefiting from nearshoring given its proximity to the US – demand for commercial real estate in the north of the country is very strong. Elsewhere in Latin America, we see value in Brazil, another commodity-heavy economy, which we consider has some of the best run companies in the world, with very high standards of corporate governance.

In summary, we believe EM equities offer investors exposure to a diverse opportunity set at undemanding valuations. In our view, these features could prove appealing to global asset allocators should the fortunes of EM improve, and the next cycle of relative performance begin. 

By Michael Bourke

The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.

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