The tailwinds for Emerging Market stocks

Jun 29, 2023

With expectations for returns on U.S. stocks limited, the time may be ripe for EM stocks to emerge from the shadows and take their turn in the spotlight thanks to attractive valuations and healthy economic fundamentals.

Right now, EM stocks are cheaper than they’ve been on average over the past 15 years—as measured by the Morningstar Emerging Markets Index—while U.S. stocks look slightly overpriced compared with their long-term average valuations based on the Morningstar US Market Index.

On average, EM stocks are cheaper now than they have been over the past 15 years. That’s in terms of their price/earnings ratios, which are a commonly watched valuation metric comparing the stock’s price with its expected or historical earnings. Meanwhile, U.S. stocks look fairly valued or even slightly expensive overall compared with their average levels over the past 15 years.

Tailwinds for EM stocks:

  • A weakening USD

“I think we’re going to see a weakening U.S. dollar that will provide a tailwind. But as investors start to realize that a ‘soft landing’ is a possibility here in the U.S.—and also in Europe and the U.K.—investors will see that other economies can actually recover. When that happens, other currencies will outperform and accelerate over time. That means opportunity for emerging markets.” - Candace Tse, managing director and global head of strategic advisory solutions at Goldman Sachs Asset Management.

  • Ripple effects from China’s reopening

China has reopened much quicker than expected, Tse says, and much of the strong growth that was expected to come forth next year is starting to happen now. “The rebound that comes with China’s reopening is not going to peter out after a quarter or two. This is a pretty significant trend that’s going to continue for some time,” she says.

Chapman Taylor, equity portfolio manager at Capital Group, which manages American Funds, shares a similar view: As China grows and needs to hire labour offshore because of changing demographics and rising labour costs, “India, Indonesia, and Mexico is where they’ll go. We see a lot of attractive companies, in Southeast Asia in particular, that will feel the derivative impacts of China’s growth. In Mexico, one very attractive sector is industrial real estate. There is huge demand for land there in terms of companies looking to set up industrial facilities in Mexico, especially Chinese companies.” In China, Taylor is also interested in the biopharmaceutical industry, as well as companies that own factories in India and Indonesia.

  • Maturing economies within EM

 New stability brought by “structural reform” is starting to pay off. Taylor cites several stats, including debt/gross domestic product ratios, which have lowered substantially for several EMs. “A number of these countries now have lower debt/GDP ratios than the developed world,” he says. They no longer have the fixed exchange rates, higher debt levels, and political uncertainty that they once had, yet “valuations are now at a discount of about 40%.”

Structural reform slows countries down for a time, and then the benefits come later, and he sees those benefits emerging now. “Indonesia has gone through several elections without a hiccup,” he says, later mentioning that the country is now home to the largest stainless steel plant in the world.

“Clearly, from a relative standpoint, EM look much more attractive than they have historically, and on a relative basis compared to the headwinds that we all see in developed markets,” Taylor says.

Justin Thomson, T. Rowe Price’s head of international equity: China is currently a cheap market with abundant opportunity from the bottom up. There are sector plays in technology within software, automation, and semiconductors. In addition, there are consumer plays—particularly where local brands are substituting for global brands—consolidation in fragmented industries, and environmental plays.

There are opportunities in India for the country’s structural growth and in Latin America because equities and financial exchange rates are outright cheap. Keeping an eye on Taiwan Semiconductor for its ability to manufacture the nodes required for AI chips.

Dan Lefkovitz, strategist for Morningstar Indexes: Equity investors in the U.S. have both tactical and strategic reasons to combat home-country bias and go global. The U.S. share of global stock market value has climbed to nearly 60% based on the Morningstar Global Markets Index, which measures the performance of stocks located in developed and EM across the world. That’s far out of proportion to its 25% share of the global economy.

Philip Straehl, global head of research for Morningstar Investment Management: EM represent nearly 70% of the world’s GDP growth, but only 20% of the total global equity market cap. A burgeoning middle class continues to develop in emerging markets and should present interesting opportunities for investors, albeit with higher volatility.

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