Partner Insight: Why You Should Consider a Better Future for EM Equities

Turnaround factors are forming to support emerging markets

clock • 5 min read
Partner Insight: Why You Should Consider a Better Future for EM Equities

Key Insights

  • A strong dollar, disappointing earnings growth, and slowing global growth make the outlook for emerging market equities challenging in the short term.
  • Those same headwinds, however, are likely to become tailwinds as we move through the next stages of the economic and equity cycle.
  • Emerging market equities have historically been an early beneficiary of global economic recoveries. Any improvement in economic conditions may represent a signal to increase allocations to the asset class.

The global economic environment is highly complex as economic indicators are flashing red, liquidity is being drained from the financial system, and equity market returns have become concentrated in specific areas. Emerging markets (EMs) have also had to deal with distinct headwinds that have hindered performance. To add to this, the yield curve has been inverted for over a year now, raising the prospects of a US recession. (An inverted yield curve has preceded every US recession for the last 50 years.)

Emerging Markets Equities Have Typically Been Early Beneficiaries of Economic Recoveries

(Fig. 1) EM equities have historically outperformed coming out of U.S. recessions

Emerging Markets Equities Have Typically Been Early Beneficiaries of Economic Recoveries

As of August 31, 2023.
Past performance is not a reliable indicator of future performance.
*Blue line represents MSCI Emerging Markets Index performance versus the MSCI All Country World Index.
Sources: National Bureau of Economic Research, FactSet. Financial data and analytics provider FactSet. Copyright 2023 FactSet. All Rights Reserved.

At first glance then, it may not seem like the ideal time to be considering allocations to EMs, particularly given their reliance on global trade and exports. However, we believe specific turnaround factors are beginning to form. In addition, if we witness a short or mild recession that many economists are predicting, then EMs may be well placed to deliver as they have historically been early beneficiaries of economic recoveries (Figure 1).

Headwinds Likely to Turn to Tailwinds

There is no argument that EMs have performed poorly versus developed markets in recent years. A strong US dollar, geopolitical tensions, disappointing earnings growth, and a narrowing of the economic growth premium versus developed markets weighed heavily on sentiment. More recently, deglobalization trends—with greater protectionism and onshoring of production—have also worked to limit growth. However, looking further out, those same headwinds could become potential tailwinds as we move through the next stages of the economic and equity cycle. With compressed valuations, a weakening US dollar, peaking inflation in many emerging market countries, and the potential for interest rate cuts, the ingredients for early stages of recovery are forming.

Valuations are particularly attractive relative to other markets. In terms of price‑to‑book, EM valuations have fallen to 1 standard deviation below historic levels (Figure 2), offering both opportunity (in terms of recovery) and further downside mitigation (as we head into a possible recession). Meanwhile, EM earnings estimates have already been marked down sharply, but we expect these to rebound as the global economy bottoms and then recovers.

Valuations Are Looking Attractive Versus Other Markets

(Fig. 2) Price‑to‑book valuations are close to historic lows

Valuations Are Looking Attractive Versus Other Markets

January 1, 2008 through August 31, 2023.
Source: FactSet. Financial data and analytics provider FactSet. Copyright 2023 FactSet. All Rights Reserved.

The Outlook Shows Promise, but Expect Bumps Along the Way

The path toward recovery is unlikely to be smooth, however, and the experience across EM countries will vary. Economies such as China, India, and Brazil, with strong domestic demand potential, are better placed to weather the challenging environment. China remains a conundrum, and even though the reopening of China following the extended COVID restrictions initially spurred investment, more recent data have been disappointing. Similarly, the underperformance of Chinese equities relative to their global counterparts year‑to‑date also reflects disappointing momentum.

 

This post was funded by T. Rowe Price

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Key Insights

  • A strong dollar, disappointing earnings growth, and slowing global growth make the outlook for emerging market equities challenging in the short term.
  • Those same headwinds, however, are likely to become tailwinds as we move through the next stages of the economic and equity cycle.
  • Emerging market equities have historically been an early beneficiary of global economic recoveries. Any improvement in economic conditions may represent a signal to increase allocations to the asset class.

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