It’s become commonplace for professional investors to venture, every December, that the year ahead might finally bring better times for emerging markets. Those hopes have rarely proved accurate. Yet this story did finally play out in 2023 – albeit not in a way that was particularly easy to capitalise on.
Headline returns for this year don’t look that alluring, particularly once you factor in the high-risk nature of EM investing. As of 1 December, the MSCI Emerging Markets benchmark was up around 5 per cent. But this mediocrity is in part due to China, which now makes up a third of the index and whose equities have collectively shed 10 per cent this year. The next largest benchmark allocations, India and Taiwan, have put in good performances. And Brazilian equities, while nowadays constituting just 5 per cent of the index, have soared.
Capturing these returns is easier said than done. Taking single-country bets involves ratcheting up risk even further. And converting returns to sterling, as all domestic investors must, ate away at performance for all these markets in 2023.
Still, there are once again reasons for optimism as 2024 emerges, even if some of this positivity is again pinned on a macroeconomic prediction that in recent years has repeatedly failed to materialise. That forecast is for a weaker US dollar, which would provide a leg up to emerging market economies in a number of ways: broadly speaking, it would reduce import costs, inflation and indebtedness, therefore bolstering political and economic stability, and it would also indicate an increase in global risk appetite.
The prediction has some weight behind it this time around. Potential interest rate cuts from the Federal Reserve should weaken the dollar’s attraction, and recent weeks have seen the greenback wane as investors bring forward their forecasts for lower rates. But things are never that simple. If the US soft landing morphs into a recessionary scenario, global investors may well run for the safety of assets such as the dollar. Equally, if the US economy dodges a material slowdown and thereby fares better than most rivals, its stock markets may rule the roost once again.
Some EM economies will be boosted by their own central banks, which are further along in their interest rate cycles. Inflation expectations for emerging economies are now closer to target than they are in the developed world, according to the International Monetary Fund, and rate cuts have already begun in countries such as Brazil – a move that has helped fuel the market rally there in the fourth quarter. Société Générale analysts expect Mexico to follow suit in February, and India by the second quarter.
It is not all about the macro; company earnings growth is also a crucial part of the story. Lazard Asset Management noted in October that “emerging markets have lagged developed markets this year partly because of weaker earnings growth”. But consensus forward 12-month earnings per share expectations have moved higher for emerging markets this year and now exceed those for developed markets – historically a promising sign. Some of this rise is due to upgrades for tech-heavy South Korea and Taiwan, but India is also among those tipped to continue to deliver.
India has been the standout performer in emerging markets over the past half-decade, and can be easily accessed by private investors via either tracker funds or the range of active funds and investment trusts available. Professional investors still point to structural opportunities, and earnings growth in 2024 should provide support. But Schroders head of emerging market equities, Tom Wilson, perhaps speaks for many when he says that “valuations in that market are currently very high and we see stronger opportunities elsewhere”, including in beaten-up Chinese shares.
Investors do not necessarily have to turn to specific countries in order to reap the rewards. For all the dismay at mainstream emerging market performance (total sterling return over the past five years: 12 per cent), small caps have – unlike almost everywhere else in the world – offered solace. Look at the major global equity benchmarks and their junior equivalents, and the MSCI EM small-cap index is the only one not to have lagged well behind its larger peer over the past five years. More to the point, its total return of 52 per cent is far out in front. Earnings growth expectations for the small-cap index remain well in excess of those for the regular EM benchmark in both 2024 and 2025. But that does leave more room for disappointment, particularly in light of the strong recent run. Anticlimaxes have become a recurring theme for emerging market investors, but hopes for the new year do have at least a little momentum behind them this time around.
