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From hope to hesitation
Over the past decade, emerging markets (EM) have experienced mixed fortunes, as strong early performance was followed by more recent lacklustre returns1 . The strong US market and dollar as well as the weak Chinese economy impacted returns. The next decade may see EM stock markets return to their former glory.
In this series, we will put into context the recent difficult period and explore the key reasons why we believe one should continue allocating to EM equities.
From the US
There are two key areas which have challenged EM performance from 2010 – 2023:
- It has been a one-way bet in the US. The US dollar strength has led to the strong outperformance of US stocks over EM across the last 13 years. Over the medium and long-term, US stocks have had significantly higher correlation with the US dollar than EM stocks do.2
- Although in the past there have been times when EM has overcome dollar strength, since the beginning of 2021, the strong dollar has been a significant headwind for EM performance.
Inverse correlation between EM performance and the US dollar over 23 years
Source Bloomberg and FactSet. Data shown from 1 January 2000 to 30 June 2024.
As we are approaching the end of the interest rate cycle in 2024 and with indications of rate cuts in the near future, there are some important implications for EM.
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Since the beginning of 2021, the strong dollar has been a significant headwind for EM performance
From China
The second significant challenge for EM investors has been the recent material underperformance of China, which represents a quarter of the asset class and is a significant driver of its returns.3
China's underperformance has impacted EM returns over last five years
Source: MSCI, returns show in US dollars for 30 June 2019 to 30 June 2024
The recent underperformance of China has dragged down asset class returns.
There are three key worries about China:
- Economic slowdown – driven by weakness in the real estate market
- Geopolitical tensions – particularly the relationship with the US
- Policy – the direction of domestic policy with regards to the private sector, Covid, and economic stimulus
Hesitation on these three factors has meant that China has seen a material valuation derating in the past few years. We think China presents a counter consensus valuation opportunity.
An Evolving Landscape
It is important to remember that the EM market is not the same as ten years ago, or even the decade before that. Since the significant outperformance of the early 2000s4, the shape of the asset class has changed. Information technology is the largest sector allocation in the asset class and commodities no longer dominate5.
Consumer-focused industries, represented by consumer discretionary stocks also represent a meaningful component of the index as we have seen tremendous growth in per-capita incomes in all of the major EM economies. Finally, we have seen the impact of the digital era as billions of consumers have been able to access new consumption opportunities within e-commerce, gaming, and digital finance.
Despite the headwinds facing EM recently, in our view, the landscape is now positively shifting and this Emerging Markets: An Evolving Landscape series will explore the key drivers with the potential to dictate the future of the asset class:
Sources
1Source: Morningstar: MSCI EM NR USD, MSCI EAFE NR USD, MSCI USA NR USD: 31 December 2000 – 31 December 2023.
2FactSet as at April 2024.
3China represents 25.1% of the MSCI Emerging Markets Index. Source: MSCI, 30 April 2024.
4Morningstar: MSCI EM NR USD, MSCI EAFE NR USD, MSCI USA NR USD: 31 December 2000 – 31 December 2023.
5Factset as at 21 May 2024.
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