Horacio Coutino, Equities investment writer
Emerging markets (EM) are, by their very nature, in an almost continual state of change and development, resulting in the constant rise of new investor opportunities. The changes taking place in Emerging markets have been amplified in the post-Covid environment as governments and businesses seek to de-risk global supply chains and trading relationships, making geopolitical connections ever more important for investors to understand.
In a year in which approximately 76 nations have either conducted or plan to hold elections, monitoring the interplay of global geopolitics with EM countries, and the potential knock-on effects across their respective asset classes is important for investors looking to diversify their portfolio risk. EM equities are often subject to mispricing due to a disconnect between their operational and financial characteristics and their listing location. While many EM companies have a diversified base of revenue and access international financing markets with investment-grade offerings, their listing on local exchanges often leads to a valuation discount compared to their developed market (DM) counterparts. Therefore, in this article we consider:
- The evolution of risk perception in EM compared to DM
- Q1 performance to date
- Earnings Growth and Profitability
- What all of these factors may mean for investors
Setting the Scene
The accommodative US fiscal and monetary policies enacted during the Covid 19 pandemic successfully stabilised markets and propelled American equities to unparalleled performance levels. However, this surge in equity performance has been challenging for other nations, especially EMs, to emulate for a variety of reasons.
In a historic development for emerging-market fixed income, last year marked the first instance of those central banks’ interest rates aligning with those in Developed markets (DM). This convergence was primarily attributable to decisions by EM central banks to adopt more restrained fiscal and monetary expansion during the pandemic, effectively maintaining lower inflation rates compared to DMs.
The convergence of interest rates, with declining rates in emerging markets, might have suggested superior performance for EM equities due to an improving economic growth outlook. However, this was not the case in 2023, as the benchmark performance of EM stocks was hampered by the disproportionate influence of China in EM market indices such as MSCI Emerging Markets and FTSE Emerging Markets. Excluding China, EM equities fared well, with Brazil, South Korea, Mexico, and India all achieving returns exceeding 20%. This divergence marked the first time in two decades that EM benchmark stock and bond indexes did not move in tandem.
The key question now is whether EM equities will align with bond performance this year. With inflation gradually decreasing in most EMs, their central banks have the capacity to further ease monetary policy. It is anticipated that most EM central banks will favour lowering interest rates, which is generally supportive of equity performance, deepening policy divergence with the US Federal Reserve (Fed) which is highly unlikely, based on its June meeting comments, to cut rates anytime before the Autumn and even then, most probably only by 25 basis points.
At the beginning of 2024 EM stock underperformance was expected to continue. The MSCI Emerging Markets index was -4.7% in January, marking the most significant underperformance for that month since 1998. Market sentiment waned as the perceived strength of the US economy fueled expectations of prolonged higher interest rates by the Federal Reserve.
However, performance rebounded in February and March, culminating in a 2.4% gain for the first quarter. This recovery, while notable, was surpassed by the more robust performance of developed markets, with the S&P 500 Index and MSCI World Index recording gains of nearly 11% and 9%, respectively.
The energy sector contributed significantly to this improved EM performance, as geopolitical tensions bolstered EM energy exporters like Brazil and Saudi Arabia. Additionally, robust macroeconomic fundamentals, coupled with AI-related optimism, elevated technology-centric EM markets such as Taiwan and South Korea.
However, the narrative of EM is one of stark contrasts and shifting risks, where country-specific dynamics play a crucial role. Some idiosyncratic risk factors that vary across EM are sensitivity to Fed policy and/or US dollar strength, credibility and autonomy of central banks, monetary and fiscal policy direction, demographic trends, inflation dynamics and growth profile.
The effect of ‘higher for longer’ in EM
The elevated interest rates in developed markets have contributed to a compression of the spread between emerging market (EM) and US corporate bond yields in USD. This spread, as of 7th June, at 78 basis points (bps), is the narrowest observed since May 2018, and lower than both the 1-year average of 115 bps and the 3-year average of 148 bps.
This can be attributed to the divergent inflationary trends between DMs and EMs. As inflation continued to rise in 2022, surpassing all forecasts, US corporate yields surged to levels unseen since the global financial crisis. Conversely, due to relatively lower inflation rates and higher real rates that helped anchor long-term inflation expectations, EM corporate yields experienced more moderate increases. As of 7th June, EM corporate bond yields stood at 6.31%, while their DM counterparts were at 5.53%, as measured by the ICE BofA US Corporate Index Effective Yield. The spread of both yields, at 0.78% was lower than the 1-year average of 1.15% and the 3-year average of 1.48% and the lowest spread seen since 1st May of 2018.
The narrowing spread may indicate a diminishing perception of risk in EMs, as concerns about inflation and credit risk subside. This suggests a growing confidence among investors in the stability and future prospects of EM economies and their corporate sectors.
Source: FRED, Federal Reserve Bank of St. Louis.
The evolving perception of EM risk is perhaps best reflected in the implied volatility of exchange rates, as currency risk permeates across various asset classes. For example, implied volatility in EM exchange rates, as measured by JPMorgan's Emerging Market Volatility Index, decreased significantly, from 12.1% on 15th March, 2023 to 6.8% on 28th May, 2024.
However, this diminished perception of risk has not translated into a broad strengthening of EM currencies against the US dollar. The Nominal Emerging Market Economies US Dollar Index reveals that the US dollar has appreciated by 2.9% against EM currencies since 15th March 2023. This appreciation can be attributed to the persistence of higher interest rates in the US, as Treasuries auctions in 2024 have seen strong demand despite supply issuance increasing 23% across the yield curve, coupled with heightened by different event risks that stem from political uncertainty surrounding EM elections.
While inflationary dynamics in the US remain uncertain due to tight labour market conditions and strong service prices, prolonged higher US interest rates continue to provide a source of yield that supports dollar strength across various currency pairs.
Source: Factset, FRED, Federal Reserve Bank of St. Louis.
Navigating EM beyond China
China's equity market has experienced a substantial decline, approximately halving in value since the beginning of 2021 when strict anti- Covid measures including quarantines essentially shut down the country. Both absolute and relative valuations for Chinese equities are still approaching historical lows due to a variety of challenges including heightened regulatory oversight, excessive real estate debt, concerns regarding potential forced reunification with Taiwan, and ongoing tensions and competition with the US, particularly in relation to access to critical technologies in the semiconductor industry.
China's alleged coercive technology transfer practices and intellectual property theft have raised concerns about its dominance in global production of critical inputs as it poses unacceptable risks to supply chains. In the US this has led to the introduction of four bipartisan bills aimed at restricting US investments in China. Additionally, the passage of H.R.7521, the TikTok divestment bill, in the House signalled a hardening stance towards Chinese companies operating in the US. Trade is also coming under the microscope with increased US tariffs under Section 301 of the Trade Act of 1974 on $18 billion of imports from China that will take effect on 1st August. A series of tariff increases have been outlined across various sectors: tariffs on steel and aluminium products will rise from 7.5% to 25%, while the tariff on electric vehicles will increase significantly from 25% to 100% in 2024. Semiconductors will also see a substantial increase, with tariffs rising from 25% to 50% by 2025. Additionally, certain critical minerals will face a new 25% tariff, and the tariff on solar cells will double to 50%. Other products subject to tariff increases include ship-to-shore cranes and medical products.
Despite displaying signs of recovery, the Chinese equity market continues to face significant headwinds, in particular within the property sector and weak domestic demand with signs of deflation. President Xi Jinping has also indicated that Beijing will prioritise national security concerns—including those pertaining to societal and political stability—alongside economic growth objectives. The attempt to balance these competing priorities poses an ongoing policy coordination challenge within China's increasingly centralised bureaucracy under Xi, leading to mixed signals from Beijing toward the private sector and dampening investor confidence.
Given these circumstances, and the heightened idiosyncratic risk it can inflict in EM Equities due to the weight it has within major EM indexes, it is prudent to consider diversifying investment strategies looking at EMs beyond China.
EM Equity Valuations
Despite the decreased implied volatility in EM exchange rates, EM equity valuations remain significantly undervalued compared to their DM counterparts.
Based on a last-twelve-month (LTM) P/E multiple, MSCI EM ex China is trading at 15.1x, in contrast to the S&P 500's 25.4x. This represents a substantial valuation discount of 40.7%, exceeding the 29.3% average discount observed since Q1 2019. Additionally, on an LTM EV/EBITDA multiple basis, MSCI EM ex-China trades at 9.9x, implying a 42.1% valuation discount relative to the S&P 500's 17.1x multiple. This current discount surpasses the five-year average of 36.9%.
Several factors could potentially contribute to a narrowing of this valuation discount. These include a stronger earnings growth trajectory in emerging markets, a recovery in EM profitability, a higher dividend yield compared to developed markets, and a widening economic growth premium in favour of emerging markets.
Source: Factset.
An examination of major emerging market (EM) economies, including India, Brazil, Turkey, Korea, Poland, Mexico, and South Africa, reveals significant variation in their valuation multiples, both in absolute terms and relative to their historical levels.
A ten-year analysis (40 quarters) demonstrates a divergence in the Q1 2024 valuations of these EMs, based on both LTM P/E and EV/EBITDA multiples. On an EV/EBITDA basis, Brazil (5.6x), Mexico (6.9x), and Poland (4.8x) are currently trading below the 25th percentile of the past decade, while South Africa's 8.1x multiple and Turkey's 7.0x multiple rank at their respective 27.5th and 37.5th percentiles. Conversely, MSCI EM ex-China (9.9x), India (16.1x), and South Korea (9.6x) are trading at or above the 85th percentile. The S&P 500's 17.1x EV/EBITDA multiple is positioned at the 87.5th percentile.
From a P/E multiple perspective, Brazil (7.8x), Mexico (13.5x), Poland (7.1x), and Turkey (6.6x) are trading below their 25th percentile. South Africa is situated at its 27.5th percentile with a 10.4x multiple. Meanwhile, MSCI EM ex-China, South Korea, and India are all currently trading at their 85th percentile. The S&P 500's 25.4x P/E multiple stands at its 90th percentile.
Source: Factset.
Recovering Profitability in EM
EBITDA and Net Profit Margins
While the S&P 500 may currently boast superior EBITDA and net profit margins compared to the broader MSCI Emerging Markets ex-China index, a closer examination of specific equity indices within the emerging markets universe reveals a more nuanced picture with some markets showcasing profitability levels that rival or even surpass those of developed market counterparts.
Brazil's Bovespa index stands out with the highest EBITDA margin among the analysed group, reaching 23.4%. On the other hand, South Africa's equity market with a net profit margin of 11.2%, implies the highest profitability in the bottom line of the group.
Conversely, South Korea's equity index exhibits the lowest figures for both EBITDA and net profit margins within the analysed group. This analysis underscores the heterogeneity within emerging markets, highlighting the importance of delving beyond aggregate metrics to uncover specific opportunities and risks.
Source: Factset.
Accelerating EPS Growth
Following a sharp decline throughout 2021 and 2022, earnings growth expectations have moved higher for EM compared to DM, including the US, over 2024 and 2025. Consensus earnings growth for MSCI EM ex China in 2024 and 2025 is 19.6% and 16.4%, respectively, compared to less than 11.7%% and 14.3% in the US. Of the countries analysed, all of them with the exception of Poland exhibit higher expected EPS growth rate for 2024.
Source: Factset.
Mexico and India: A tale of two political risk-events
Although valuation and EPS growth acceleration can be shared drivers for EM equities, local context and idiosyncratic factors unique to each market can have a significant impact. The recent elections in Mexico (2nd June) and India (19th April to 1st June) are prime examples.
Mexico’s political upheaval: In the 2nd June general elections in Mexico, the populist-nationalist political vision of Obradorismo led to sweeping victories across all levels of government. The incumbent administration not only secured the presidential office by a historic margin, but also significantly bolstered its footprint in Congress, achieving a supermajority in the House and approaching one in the Senate. It also further solidified its influence within local governance structures.
However, policy risk-premia rose following the election. The electoral outcome led to a reassessment of risks associated with this newfound "super-majority," which appears to overshadow the benefits of political continuity.
The market reaction was predominantly negative, with the Mexican peso -7.7% since the election, while the S&P BMV/IPC is -5.5% driven by heightened concerns over the potential approval of 18 constitutional reforms introduced to Congress in February. These proposed reforms are perceived as posing risks to institutional integrity, potentially weakening existing checks and balances and the separation of powers. Moreover, some are viewed as investment unfriendly and could pose medium-term fiscal challenges, potentially leading Mexico towards weakened macroeconomic and institutional fundamentals. These would place a higher policy and institutional risk-premia on Mexican assets. This is already evident in the post-election repricing of Mexican assets.
The near-term legislative agenda is likely to set market direction over the interim period spanning the four months between the election and the 1st October inauguration, with public statements by the president elect and key cabinet appointees and advisors likely to sway markets..
The fiscal outlook for the upcoming presidential term presents a less than rosy picture. Increased expenditures on pensions and social programs, combined with the depletion of counter-cyclical funds and an increased reliance of PEMEX for government subsidies under the previous administration, contributed to a more constrained budgetary environment.
Mexico: A thematic strategy based on the enhanced policy risk-premia. Our Equity analysis is strategically focused on sectors poised for directional certainty over the next six years. Uncertainty within concessionary and regulated industries like mining, rail, and power can be expected. Unregulated industries, particularly consumption related, appear to offer a refuge from this risk.
Against this backdrop, the indiscriminate sell-off of the Mexican stock market with the S&P BMV/IPC -5.14% as of 14th June, presents opportunities in specific industries. Consumption is likely to remain robust due to continued social programs and healthy remittances, favouring companies like CUERVO, Coca-Cola FEMSA, Kimberly-Clark, and Tiendas 3B. Nearshoring trends remain intact, potentially benefiting Mexican industrial REITs, and VESTA, despite lingering uncertainties regarding bottlenecks. Additionally, airports (ASUR, GAP) stand to gain from nearshoring, a healthy consumer environment, and completed regulatory reviews. Lastly, cement operators (CEMEX, GCC) are well-positioned due to their exposure to US dollar-denominated revenues, robust domestic consumption, and nearshoring trends.
It is worth noting that companies with significant US dollar-denominated debt or capital expenditures may be more susceptible to heightened risk premiums, as reflected in increased volatility of the Mexican peso (MXN).
India’s macro stability, growth story remain intact as policy continuity prevails. Based on the official vote count on 13th June, the BJP-led NDA alliance secured a reduced majority in India's Lower House (Lok Sabha) elections compared to its previous two terms. The alliance secured 292 out of 543 seats, significantly less than the average exit poll prediction of over 360 seats, yet surpassing the majority threshold of 272. Although this less decisive mandate may pose challenges for implementing certain structural reforms, the overall policy continuity, macroeconomic resilience, and robust growth fundamentals should maintain the relative appeal of Indian equities.
Following the preliminary official vote count on 4th June, India’s equity market experienced a sharp sell-off, with the MSCI India index -6.4%, and most cyclical sectors closing 10% to 15% lower. However, the market subsequently rebounded, +9.0% in the following ten days, validating the constructive outlook for Indian equities. While valuations are not inexpensive at 24.2x PE ratio, India continues to deliver strong earnings growth. After a 20% increase last year, Q1 profits exceeded consensus estimates, reaching 16% y/o/y growth. Additionally, projected earnings growth for FY24 and FY25 stand at 15.0% and 15.4%, respectively. While strong earnings performance can drive returns, foreign flows, which have been subdued this year, may strengthen post-election, consistent with previous cycles. Foreign investor positioning in India remains light, as evidenced by low foreign ownership (at an 11-year low) and underweight mutual fund positioning (excluding banks).
Furthermore, on 10th June, the newly formed NDA government announced the allocation of portfolios to the Union Council of Ministers. These allocations signal policy continuity within the Cabinet, with the majority of key ministries remaining under the leadership of ministers from the previous (2019-2024) government. The BJP retained 25 out of 30 cabinet appointments, while allocating 5 cabinet seats to coalition partners. The new government is expected to adhere to the path of fiscal consolidation, maintaining a focus on infrastructure development, particularly through expanding the rail network, while also exhibiting a slight inclination towards increased rural spending.
The Finance Ministry remains under the leadership of Minister Sitharaman, who held the same position in the previous term. The central government has demonstrated a commitment to fiscal consolidation, reducing the fiscal deficit for FY24 (April 2023-March 2024) to 5.6% of GDP, below the revised estimate of 5.8% of GDP (and the initial budget estimate of 5.9% of GDP). The government has previously announced a fiscal consolidation target of 5.1% of GDP for FY25.
India: A thematic strategy aligned with medium-term policy goals. Our Equity analysis focuses on the likely key policy priorities of the NDA government's third term, based on announcements in the BJP's 2024 Manifesto (Sankalp Patra), and subsequently identified sectors and areas that allow investors to align their portfolios with these medium-term policy objectives in four major focus areas: tourism, rural support and agriculture infrastructure, energy security and railways.
In the tourism sector, the incoming government aims to enhance connectivity and infrastructure to boost tourist arrivals, develop religious and tourist destinations, promote island tourism hubs and adventure tourism. Companies like InterGlobe Aviation, Indian Hotels, and MakeMyTrip are expected to benefit.
In terms of rural support and agricultural infrastructure, policies are being created to enhance farm productivity and income. This includes supporting the production of pulses and edible oil, establishing new clusters for vegetable production, incentivizing crop diversification, and implementing agri-infrastructure projects like cold storage facilities, irrigation, and food processing. Companies including Mahindra & Mahindra, Patanjali Foods, and UPL are likely to be positively affected by these initiatives.
In energy security, the government seeks to reduce energy dependence through a combination of electric mobility, a network of charging stations, renewable energy production, and improved energy efficiency. Key projects include establishing mega solar and wind parks, developing a Green Energy Corridor, incentivizing private investment in large-scale Battery Energy Storage Systems (BESS) infrastructure, and increasing Green Hydrogen production capacity. This is expected to benefit companies such as Reliance Industries, NTPC, and Bharat Heavy Electricals.
In the railway sector, the focus is on promoting manufacturing and R&D, expanding the railway network, redeveloping railway stations, and expanding metro networks in major urban centres. Policy emphasis on enhancing railway infrastructure should lead to sustained demand for goods and services within the railway supply chain, leading companies like JSW Steel, Larsen & Toubro, and Jindal Steel & Power to gain from these developments.
Key Risks for EM Equities in 2024
While 2024 has commenced on a relatively positive note, there are several potential challenges to growth in emerging markets over the rest of the year:
China will potentially remain a laggard to the EM world due to a contraction in the domestic housing sector, rising geopolitical risk vis-a-vis Taiwan and the US, deflation and its generally unbalanced economic structure.
Bond yields in DMs remain elevated, with the exception of Japan. The Fed, in particular, awaits further evidence of disinflation. Market expectations for Fed rate cuts have retreated to less than two cuts this year. Consequently, US 10-year Treasury yields remain high and the US dollar is approaching multi-decade highs. While a resumption of Fed rate hikes this year appears unlikely, a further delay in rate cuts exert further pressure on EM currencies and debt levels issued in USD.
There is a risk of escalating protectionist trade measures, primarily stemming from the upcoming US election and in the after effects of the EU parliamentary election. President Biden recently announced significant tariff increases on various Chinese sectors, including electric vehicles (EVs), semiconductors, and steel. His opponent, former President Trump, has proposed a 10% across-the-board tariff and 60% tariffs on China, measures that would undoubtedly have adverse effects on Chinese economic activity and exert downward pressure on the Renminbi (RMB) and potentially other EM currencies, particularly in Asia.
The imposition of such trade restrictions could have profound implications for EM equities. During former President Trump's initial term, average tariffs on Chinese goods quadrupled from 3% to 12%, prompting a substantial realignment of supply chain strategies and the geographic sourcing of US imports. Consequently, total US imports from mainland China declined significantly, from a peak of 21% in mid-2018 to 14% by the end of 2023. Notably, the eurozone, other emerging markets in Asia, Mexico, and Canada all benefited from China's diminished market share. As of 2023, the Eurozone and Mexico have emerged as the two largest suppliers of goods to the United States, accounting for 17% and 15% of the market share, respectively.
The ongoing conflict in Gaza has precipitated an increase in confrontations across the Middle East. Attacks in the Red Sea have caused a substantial rise in freight rates and transit times, with hundreds of vessels opting to reroute an additional 4,000 miles around the Cape of Good Hope in South Africa. Consequently, there has been a sharp decline in passages through the Bab el-Mandeb Strait near Yemen and the Suez Canal in Egypt.
Beyond the Red Sea, drought-induced disruptions in the Panama Canal have led to a surge in sea freight rates from China and other East Asian economies, with increases of up to 275% since early December 2023. Looking ahead, the inflationary impacts could intensify if maritime disruptions persist and adversely affect energy flows. While crude oil prices have remained relatively stable so far, a closure of the Strait of Hormuz, through which nearly 20% of global oil supplies transit, could trigger a significant spike in oil prices.
Conclusion
The economic outlook for emerging markets (EMs) is inextricably linked to the evolving dynamics of global trade. Increasing protectionist measures, rising geo fragmentation, ongoing trade tensions, and shifts in supply chains present a complex landscape of both risks and opportunities for these economies.
Potential headwinds to EM growth include the delayed impact of elevated interest rates, which may increase debt servicing costs and hinder new investment. Additionally, a projected slowdown in the US economy during the latter half of 2024, combined with a fragile recovery in the eurozone, could further dampen EM economic activity. The uncertain trajectory of China's economy, marked by concerns over its property sector and subdued confidence, also poses risks for EMs.
Furthermore, a busy electoral calendar across various EMs, such as the recent Mexican election, may lead to reduced policy predictability, potentially discouraging investment in certain cases.
However, despite these challenges, opportunities exist for investors. The current valuation discounts in PE and EV/EBITDA ratios for EM equities relative to DM equities exceed their respective five-year averages. This divergence presents a potential valuation upside risk.
EMs also offer an attractive diversification alternative for investors, as their correlation with major DM equity indices, such as the S&P 500 and Stoxx Europe 600, tends to weaken during periods of low volatility.
Source: Factset, Exante research.
Strong EPS growth profiles for 2024 and 2025 across major EMs, underpinned by accelerating EM GDP growth, further support a bullish EM outlook. This growth momentum can be attributed to a moderate recovery in manufacturing, relatively stable financial conditions, and improved household real income growth as inflation subsides in EMs.
Active management is crucial due to significant dispersion among EMs. Moreover, local political events, or event risks of any nature, can amplify volatility across a country's asset classes to varying degrees.
While every effort has been made to verify the accuracy of this information, EXT Ltd. (hereafter known as “EXANTE”) cannot accept any responsibility or liability for reliance by any person on this publication or any of the information, opinions, or conclusions contained in this publication. The findings and views expressed in this publication do not necessarily reflect the views of EXANTE. Any action taken upon the information contained in this publication is strictly at your own risk. EXANTE will not be liable for any loss or damage in connection with this publication.
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