Can the bounce in emerging-market stocks last?

Emerging-market (EM) stocks have had a long and tough time. Since their peak in late 2010, EM stocks haven’t done as well as globally developed stocks because of both macroeconomic and market problems. Now, a change in the way the world’s markets work may actually help struggling stocks in the developing world.

There is a hint of hope in China and other emerging markets. EM stocks may be getting away from some bad trends that have been going on for more than a decade.

Some headwinds might even become tailwinds after 2023. And now that valuations and earnings predictions have dropped sharply, it seems like a good time to start looking at the developing world again. In fact, since the bottom on November 1, 2022, EM and Chinese stocks, which had been dragging down the EM index for the past few years, have started to do better. Can this jump keep going? We think so because of the following:

The growth gap is going to get bigger. In the past, one of the most appealing things about EM stocks was that their economies were growing faster than those of developed countries. But that difference in growth kept getting smaller (display) as many EM countries got over the effects of China’s rapid growth in the early 2000s. After that, EM currencies were changed to be worth less, companies deleveraged their balance sheets, and commodity prices fell over the next ten years, which all worked together to limit the returns on EM stocks. In recent quarters, these factors were made worse by the fact that EM economies had to deal with a rapid tightening of financial conditions when most central banks raised interest rates to undo years of monetary easing.

Now that most of these changes have been made, productivity gains and favourable demographics could play a bigger role in driving economic growth in EM than they have in the past.

This year, several things could start to change how growth works. While growth in developed markets (DM) slows down, growth in emerging markets (EM) is expected to stay strong, thanks in part to China’s push to reopen.

Since the 20th Communist Party Congress in October, the government has moved quickly to reopen the economy and emphasise growth. As COVID restrictions are eased, consumer confidence is likely to rise again.

At the same time, consumers should spend more because they are saving more than ever before.
We also see signs that inflation is going down in India, Brazil, and other emerging markets. As inflation slows and the US Federal Reserve gets closer to the end of its tightening cycle, some EM central banks may feel confident enough to stop or reverse their own tightening cycles, which have slowed economic growth over the past two years.

Some EM economies will benefit from changes in the way supply chains work. Many companies are moving away from China and making their supply chains more diverse. Because of this, factories are moving to places like India, Indonesia, Vietnam, and Mexico. For example, global auto and auto parts manufacturers are becoming more interested in Indonesia because it has a lot of natural resources and can provide key parts for electric vehicles, like nickel and copper. Vietnam and Mexico do well because they are close to China and the US, respectively, and because supply chain networks are already in place.

On the Margins: Profitability Differences Are About to Come Together

In the last ten years, it has been hard for emerging companies to grow their profits. Since COVID started, there has been a big difference between how profitable US and EM companies are. This is because US megacaps have been the most profitable and prices have been rising faster than costs.

Even though American companies have a good track record of coming up with new ideas and reinventing themselves, it will probably be harder to make a lot of money than it used to be. Weaker economic growth in the US, pressure from regulators on big tech companies, and higher labour costs could make US margins smaller and help EM companies close the profit gap.

How Countries and Businesses Use Money
Emerging markets are often affected by changes in the value of their currencies. In the past few years, the strong US dollar has caused many problems. It made prices in US dollars less competitive and changed how EM countries and companies with external balances could get money.

After going up for a few years, the US dollar seems to have reached its peak in September. If this trend keeps going, currencies could give EM stocks a boost. This is because, in the past, there has been a strong link between foreign portfolio flows to EM and the US dollar. If growth outside of the US helps slow down the rise of the US dollar, we would expect more money to flow into EM stocks.

Valuations and expected earnings: A good place to start
After a few rough years, investors are right to be worried about EM stocks. To get rid of the uncertainty, you need to know the answer to one key question: what is priced into current valuations and what isn’t? Since their peak in 2022, earnings expectations have dropped by about 16%. In many global DM sectors, on the other hand, earnings expectations haven’t changed much. Now that the economy as a whole is better for EM, we expect earnings growth to pick up again. When compared to their own history and that of developed markets, EM equity prices appear to be in good shape. At lower prices, we think investors have a better chance of making money if the headwinds continue to weaken and maybe even turn into tailwinds. After the big drop, we see “value” in growth stocks. Still, we think there are good opportunities all over the market, including in value stocks and stocks with less risk.

The road ahead won’t be easy, that’s for sure. As the world’s two largest economies collide and economies and companies work to realign their supply chains amid geopolitical tensions and a trade war, fears could come back. In the same way, EM economies look better than they did during the last “taper tantrum,” but politics and populism could get in the way of fiscal consolidation, causing volatility. So, we think that even when things are going well, the best way to find EM companies with strong business fundamentals and long-term return potential is to be very selective and invest actively.

Different risk-return preferences and long-term goals will call for different ways of doing things. Finding the right approach now is the first step to getting ready to take advantage of the potential EM equity recovery in the years to come.