Are emerging markets ready to rally?

Is it “time for a fresh look” at emerging markets (EMs)? asks Russ Mould of AJ Bell. The investment category has underperformed developed markets (DMs) for over a decade, leaving it at a steep discount to the US-dominated DM index. EMs trade at a roughly 35% discount to developed markets, with their weight in the average global mutual fund declining from 13% in 2010 to just 5% today, says Tom Stevenson in The Telegraph. Now, with global interest rates falling, they could be due a revival. The two key ingredients will be “China and commodities”. Beijing’s recent stimulus plan has lifted sentiment: Chinese shares are the largest single component of the MSCI EM index, a widely used benchmark. As for commodities, while the short-term picture is weak, long-term structural growth in demand for green transition metals heralds a favourable wind for the likes of Chile and Indonesia.

There have been pockets of strength, says Jay Jeon of Research Affiliates. Aided by booming demand for artificial intelligence semiconductors, Taiwan has returned more than 20% a year over the past five years, with India returning 17% per annum over the same period. Still, both markets now have valuations “that appear to be stretched to extremes”. Investors should not bank on continued outsized returns. “We are setting up for a major correction in India within the next year. People are so euphoric,” Ajay Krishnan of equity manager Wasatch tells Craig Mellow in Barron’s. Mellow suggests that investors instead investigate other more niche parts of the EM sector. The UAE is enjoying a listings boom. Southeast Asian countries, meanwhile, are “well positioned for the continued shifting of global supply chains”.

Emerging market dynamism doesn’t mean returns

A key attraction of emerging economies is their greater dynamism and growth potential, says Derek Horstmeyer in The Wall Street Journal. Yet, over the past decade, of the seven fastest-growing economies only one (India) has seen positive annual equity returns. “China, the Philippines, Vietnam, Turkey, Indonesia and Malaysia all averaged negative returns.”

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How can this be? One factor may be that investors become overexcited, pricing in even better growth than that which ultimately occurs. There is also evidence to suggest that strong economic growth in EMs is often accompanied by a weakening currency (which makes exports more competitive). While stocks soar in local currency terms, foreign investors thus lose out. China and India show that growth doesn’t necessarily bring gains, says Edward Chancellor on Breakingviews. Chinese GDP growth has comfortably outstripped India over the past 15 years, but India has delivered far better equity returns.

The key factor is capital scarcity. Investment funds are plentiful in China because of the country’s “vast domestic savings”. That has caused overinvestment in unprofitable ventures, such as property. India finds itself in the opposite position, with expensive capital forcing companies to be disciplined. Gillem Tulloch of GMT Research estimates that between 2014 and 2023, Indian corporate return on equity (ROE) averaged 10%-13%, while in China it fell from 10% to 6%. When a market becomes saturated with investors’ cash, high returns are unlikely to last.

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