Asset Allocation Strategy
27 May 2024
Signs of Life in the EM Trade
Emerging Markets Regain Some Lost Ground

Emerging market (EM) equities have been delivering improved relative performance in the last few months after disappointing through much of 2022 and 2023.

There appear to be a number of factors driving the bounce back in recent months including:

  • Better than feared China economic data flow.
  • Moderate upgrades to global growth forecasts.
  • A range trading US dollar.
  • Strong performance from Taiwan equities via the (AI driven) semiconductor sector.
  • A crescendo of negative sentiment toward China (and by association EM equities) in January, creating the platform for a contrarian bounce back.
Figure 1: EM equities performance has improved in recent months

EM valuations remain attractive versus Developed Market (DM) equities and the EM earnings growth outlook continues to look appealing. At face value EM equities have the most attractive price for growth metrics of any major region, or major country, however, a number of uncertainties and tail risks continue to keep our stance at a neutral position.

While the consensus earnings growth forecast for CY24 and CY25 suggests EM is a compelling proposition, investors remain wary of potential earnings disappointment. From this perspective investors are likely to gain some incremental comfort from the minimal downgrading of forward estimates so far in 2024. Better than feared China and global growth outcomes have undoubtedly helped earnings estimates hold up, albeit investor conviction is still relatively low.

Figure 2: EM "price for growth" metrics look relatively attractive
MSCI World US Europe Australia EM
1 Yr Fwd PE 19 21 14 17 12
CY24 EPS growth (%) 10 10 4 -1 20
CY25 EPS growth (%) 13 14 10 6 16

Source: Refinitiv, Wilsons Advisory.

Figure 3: EM is trading on a large discount to developed world equities despite higher expected growth

EM and Geopolitical Uncertainties

The geopolitical environment continues to weigh on EM from a number of perspectives and remains the primary factor keeping us from a neutral to overweight position on EM.


The US Election and the Trump Factor

The US presidential election in November does loom as a risk factor for EM equities. In our view, a Biden victory would likely continue the status quo. The Biden administration recently announced tariff hikes on some Chinese imports including electric vehicles, batteries, solar cells, chips, ship-to-shore cranes and certain types of steel, aluminium, critical minerals and medical supplies. Biden’s intent was very much a politically motivated announcement effect. The total value of products are worth around USD18bn which is only 4.2% of total US imports and less than 1% of total Chinese exports. However, it seems very likely that a Trump victory would result in a much more aggressive trade confrontation with China. Although specifics are not completely clear, Trump has suggested a 60% import tariff on Chinese products and as well as a universal 10% import tariff if elected. 

Such trade restrictions if they are indeed enacted would likely have significant consequences for EM equities. During Trump’s initial presidency, tariffs increased from 3% to 12% on average, causing a considerable shift in supply chain strategies and the geographical sourcing of US imports. Total US imports from Mainland China decreased from a high of 21% in mid-2018 to 14% by the end of 2023, with the euro zone, the rest of EM Asia and Mexico, gaining from China’s reduced market share. The euro zone and Mexico are now the two biggest exporters of goods into the US, accounting for 17% and 15% market share, respectively. 

The proposed 60% tariff on all Chinese imports next year would add impetus to these supply chain shifts. While China’s US market share would likely be seriously eroded, this would be at least partly offset by gains in other EM economies such as Mexico and South East Asian nations, despite the possibility of broader global tariffs. Nevertheless, we see potentially greater trade frictions with China as negative for China and likely negative for broader EM sentiment.


China’s Global and Domestic Political Strategy

After a strong bounce out of the pandemic investor perceptions of China as an investment destination have been negative for a number of reasons, including; increased regulatory oversight of the Chinese corporate sector, a weak economic recovery in the post COVID-19 environment, concerns over a potential forced reunification with Taiwan, and broader ongoing tensions with the US, particularly in respect of access to critical technologies. 

We believe Chinese and EM equities could, all things being equal, potentially climb the wall of worry under a second Biden presidential term, despite the ever-present tail risk of a potential forced Taiwan reunification. We don’t have a strong view on the probability of a forced reunification, albeit, we see the risks over the next few years as on the low side, given China’s focus on reinvigorating its domestic economy.

From the perspective of domestic China politics, we actually believe the ground has shifted considerably from the stance of the Chinese leadership toward the corporate sector of 2 to 3 years ago. The Chinese leadership wants growth and innovation. The equity market is also increasingly viewed as a source of common prosperity given the downbeat prospects for property. So, all things being equal, domestic policies are likely turning from headwinds into at least modest tailwinds for much of the Chinese corporate sector.

Figure 4: China has been the big EM laggard in recent years

Chinese Economy Constrained But Far From Stagnant

Another factor behind weakening confidence in the Chinese economy has been its real estate downturn. This has contributed to weak performance of Chinese equities over the last couple of years. While the Chinese property market remains a source of uncertainty and a drag on the Chinese economy, we continue to see it as manageable, with low risk of a full-blown crisis. Chinese growth has slowed since it has lost the property tailwind, however, China continues to grow at a decent rate (~5% real GDP growth). 

We see China in a glide path toward developed world growth rates. However, China will continue to grow at a pace significantly above the developed world pace for some time to come, despite its property overhang and unfavourable demographics. China continues to invest in traditional infrastructure as well as in new industries.

When combined with a more supportive stance of the leadership toward the corporate sector, this suggests there will be abundant stock-specific opportunities for investors prepared to trade-off potential high returns against geopolitical risks. We see risks as reasonably well discounted given the big “price for growth” discounts for Chinese growth companies versus the rest of world. 

Figure 5: China housing activity is no longer a tailwind for the Chinese economy
Figure 6: China continues to grow at a decent pace, albeit, more moderately than historically

From a broader perspective the EM complex continues to offer exciting growth opportunities at mostly reasonable valuations. While we note that EM has disappointed in recent years and indeed been a laggard versus global developed equities over the past 10 years or so, EM equities have a history of outperforming and underperforming in “long waves”. In broad terms we note that decades of underperformance have traditionally given way to a decade of outperformance.

Figure 7: EM performance has typically followed "long waves" (Australian dollar total return p.a.)

Key drivers of these long waves appear to be 1) the trend in the US dollar and 2) relatively weak versus strong earnings momentum (we note a link here with both the US dollar and the general trend in global growth).

Figure 8: The trend in the US$ has historically been important to EM performance
Figure 9: Earnings growth/delivery has also been important to how EM performs

From the current relatively cheap starting point with light investor positioning it is quite feasible that the next decade delivers stronger EM performance driven by a weaker US dollar and relatively better earnings growth in EM due to superior economic growth dynamics, underpinned by a growing middle class.

Geopolitical risks remain in terms of both cyclical risks (Trump 2.0) and structural risks (tail risks around a significant China US confrontation). We continue with a broadly neutral allocation to EM with Fed policy cycle (and its link to the US dollar) and the US election important signposts to take a more or less positive stance later this year.

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Written by

David Cassidy, Head of Investment Strategy

David is one of Australia’s leading investment strategists.

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