Is it Time to Dip a Toe in Emerging Markets?

Many believe emerging markets will benefit more than most asset classes from the recent US Federal Reserve interest rate cut. EM debt and equities historically perform well when the US embarks on an easing cycle not associated with a recession. With reduced external borrowing costs and an expected “soft landing” in the developed economies in the US and Europe, in combination with attractive valuation and faster earnings growth, emerging market enthusiasts believe we’ve entered a new era heralding emerging markets outperformance. We understand the optimism, and believe there will be emerging market country beneficiaries, but point out the anti-homogenous nature of the asset class with some emerging markets still subject to volatile boom-bust cycles due to factors independent of interest rates. Thus, while we believe the asset class should perform better, we think it prudent to remain selective in the EM investment space.

In the short-term, lower US interest rates encourage investment in currencies offering higher yields, putting downward pressure on the US dollar, and boosting capital flows into the EM asset class, which pushes prices higher.  Witness the recent outperformance of emerging market debt for the two months ending September 20, 2024.  Anticipating the Fed rate cut and benefiting from declining developed market interest rates, the EM debt index(1) (+4.59%) climbed steadily compared to the volatile and modest global equity return of +0.81%(2) over the same period.  The weakening dollar relative to emerging market currencies provided over half of the gain for US-based investors.  However, two months does not a trend make, and notably, the EM equity asset class has only outperformed US and global equities since September 11th.  Looking further back, it’s been a difficult decade for emerging market equity investors.  Emerging Market equities(3) managed just a 3.32% advance per annum for the ten years through September 20th compared to the 13.03% annualized result for the S&P 500.  In the prior decade, however, EM equities outpaced the US (+11.59% versus +8.25%) and for the decade ending September 20th, 2009, Emerging Market equity investors happily received an annualized +11.24% return compared to the -0.45% annualized loss for the S&P 500.  This historical perspective illustrates the cyclicality of asset classes as they fall into and out of favor.

While an accommodative US Federal Reserve is important, it’s too simple to state this to be the only factor determining the business climate across the emerging markets landscape. Other developments can and will drive the local market. In Mexico, for instance, investors express concern over President Andres Manuel Lopez Obrador’s controversial judicial reform. Chile’s market tends to follow copper prices. Turkey’s market focuses on their own central bank which lacks independence and has been known to pursue counterproductive policy. Eastern Europe, recently rocked by devastating floods, needs reconstruction with investors expecting government spending support. Select Asian markets monitor China economic and central bank developments given their trade dependence. Notably, a recent reserve ratio cut by China’s central bank and talk of fiscal stimulus spurred equity gains throughout the region. However, information technology-dependent Asian economies like Taiwan and South Korea may stress over Apple and Samsung supply chain adjustments or new US efforts to block China’s access to advanced semiconductor technology. While all emerging markets share the common characteristic of having per capita income levels below more advanced economies, there are key differences in valuation, growth, sector exposures, and vulnerabilities. We believe investors should weigh these differences when considering an investment in the asset class.

In the longer-term time horizon, we believe Southeast Asia offers the greatest profit growth potential in the emerging market universe. With attractive valuations and strong fundamentals, the region should continue to garner greater capital flows as a result of the Federal Reserve easing cycle. With their own central banks also cutting interest rates, the boost in business activity will increasingly reveal the region’s comparative advantage. As we’ve highlighted before in previous commentaries, most recently in The Rise of Southeast Asia – July 31, 2023, we believe ASEAN represents an especially attractive investment opportunity. Lower wage rates, workforce upskilling, better infrastructure, and advanced technologies induces globally-oriented companies to transform supply chains by de-emphasizing China, with greater emphasis on neighboring ASEAN countries. Recent US foreign direct investment (FDI) data highlights this phenomenon. According to the Bureau of Economic Analysis the US direct investment position in Singapore alone exceeds $424 billion as of the end of year 2023. This dwarfs US direct investment in both China and India by 3.5 and 8.6 times, respectively. Accordingly, our International and Global strategies hold investment positions based in multiple ASEAN countries. Our banking and finance-oriented investments based in Singapore, Thailand, and Indonesia, in particular, benefit from the region’s growing importance to the global economy, providing financing for crucial infrastructure, rising trade balances, and greater consumer spending. Our shipping investment provides critical goods transport both intra-ASEAN as well as between China and ASEAN. We note that although the decoupling in the technology supply chain between the US and China continues, many leading companies in the industrial, consumer, and commercial sectors from Asia, Europe, as well as North America continue to depend on China for a large percentage of their profits. Other select EM investments feature companies positioned to earn greater profits from the faster retail industry growth exhibited in many emerging countries, as well as those leveraged to the strengthening US – Mexico trade relationship.

In summary, we believe investors can enhance returns through a prudent allocation to carefully selected emerging market companies. We believe this is a better approach compared to trying to time EM investments based on central bank policy and better than a shotgun approach of investing in EM through an ETF or mutual fund. That said, investments should be diversified, as investing in a single country in isolation, even the US, can be detrimental to long-term investment success given the cyclical nature of global capital markets.

[1] Measured by the iShares J.P. Morgan USD Emerging Market Bond ETF
[2] Measured by the SPDR Portfolio MSCI Global Stock Market ETF
[3] Measured by the MSCI Emerging Markets Index

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