• No two cycles are alike, but certain factors are typically present in each episode of sustained EM stock outperformance, such as widening growth differentials and a weaker dollar.
• The case for broad EM outperformance remains contingent on the U.S. achieving a soft landing and lower risk of protectionism after the election.
• Countries in the EM space today show far less homogeneity in their policy paths and responses to global trends, favoring a selective approach to EM exposure.
Among emerging market stock investors, it is still common practice to compare the performance of their asset class relative to developed markets. Based on this convention, the past decade of relative performance has not been kind to emerging markets (“EM”), which trailed their developed market (“DM”) counterparts by nearly seven percentage points per year. Adjusted for risk, the unfavorable gap is even wider as EM stocks experienced higher volatility. This lackluster relative performance is almost the mirror image of the trend from the first decade of the 2000s, when EM enjoyed a period strong growth, improving fundamentals, and superior returns. As these prolonged cycles played out, investors repeatedly tried – and often struggled – to call inflection points, relying on tools such as relative valuations and analyses of policy shifts in major economies.
While the drivers of EM cycle outperformance are complex and no two episodes are entirely alike, some factors are typically present. Historically, growth differentials matter, specifically a widening gap over time in favor of EM. The prolonged derating of EM means relative valuations do not look stretched. Sustained dollar weakness is typically another ingredient for EM outperformance, a scenario that requires a U.S. soft landing to materialize. Higher commodity prices tend to be a net positive, too.
A review of factors associated with across-the-board EM stock outperformance indicates that all conditions are not yet in place. Uncertainty over the ability of easing by the Federal Reserve (the “Fed”) to prevent a recession, along with the risk of U.S. protectionism, represent the main near-term hurdles with implications for the dollar and global growth.
Supportive global growth and trade backdrops are critical for EM returns. The early- August market jitters underscore the importance of global activity to the EM narrative. Weak employment data in the U.S. triggered a growth scare, which quickly went global; these fears quickly faded on the back of stronger data, leading to a rebound in both EM and DM shares (TRG’s Macro Conversation: August 2024). Sustained EM outperformance hasn’t coincided with periods of economic expansion alone, but also with a widening in growth differentials in favor on EM economies (see Figure 1). Currently, IMF forecasts point to a slightly narrowing EM-DM growth gap in coming years, suggesting that this condition is not fulfilled.
Second, EM equities tend to outperform when the dollar is weakening (see Figure 2). In August, the dollar saw its sharpest decline since November of last year, a move spurred by growing market confidence that the Fed will begin lowering rates in mid-September. The fading of the early-month growth shock also contributed to dollar weakness, bringing into focus the importance of a U.S. “soft landing scenario” – a “sweet spot” where growth and inflation run near trend. If the narrative behind the Fed’s easing cycle were to shift from policy normalization to a move in response to a recession, then EM currencies and equities are unlikely to benefit. In fact, some analysts compellingly point out that EM outperformance coincides with both a weaker dollar and modestly rising U.S. stocks1. These two conditions – prospects for dollar depreciation and a rising U.S. market – seem compatible with a U.S. soft landing scenario.
As the producer of most commodities, EM outperformance is also associated with rising prices. There are two main channels. The first is that higher commodities amount to a positive income shock for exporters. In turn, this positive terms-of-trade shock tends to lead to improving external – often fiscal – balances, higher investment, and stronger currencies. The second is more directly through higher earnings growth – the index weight of energy and materials companies is nearly 50% larger in EM than in DM. There has been a disconnect in recent years between rising commodity prices and EM underperformance, part of which can be attributed to the war-related shock, China’s woes, and the gains linked to U.S. technology.
Last, relative valuations tend to reach stretched levels around inflection points. Various valuation metrics in EM seem low by historical standards, both relative to DM and on a standalone basis. Cheapness is not a catalyst, however, leaving the case for EM outperformance more dependent on the growth backdrop, U.S. rates, and the dollar. Moreover, part of the broad derating of EM is justified on relatively weaker earnings growth and lower corporate profitability. On the former, we note that after a decade of near zero earnings growth in dollar terms (versus an average of 6% per year for DM), EM earnings are expected to post double-digit gains in the 2024-25 period (see Figure 3).
Our EM-wide observations mask important policy and fundamental shifts at the country level that took place during recent cycles. During the last period of sustained EM outperformance in the 2000s, the region enjoyed the benefits from a widespread shift towards trade and financial liberalization, the build-up of external buffers through reserve accumulation, sounder monetary policymaking, and efforts to strengthen fiscal accounts (with some of these reforms advancing out of necessity following crises). Importantly, these shifts came at a time when the global consensus understood globalization and other forms of collaboration to be mutually beneficial, and the world’s major powers coexisted in peace.
In the EM space today, we find far less homogeneity on how countries are responding to secular global trends and in their policy paths. The notion that globalization is the tide that lifts all boats has been replaced by steps towards protectionism and national security imperatives, creating winners and losers in the process. Efforts to shore up fiscal finances – in both EM and DM – are clashing with demands for wider safety nets, often leading to the rise of populist alternatives. The impact of AI, which so far has mostly benefited Asian producers of hardware and data-center hosts, is unlikely to be even, either.
Luis Arcentales
luis.arcentales@rohatyngroup.com
Luis has over 20 years of experience in covering global macroeconomics and markets. He is responsible for formulating market strategy at TRG. Prior to joining TRG, he had a short stint as an independent macro researcher following a nearly two-decade career at Morgan Stanley in New York. In his role as Senior Economist, his primary focus was developing the macroeconomic and political outlooks for countries in Latin America, in addition to publishing on topics ranging from the business cycle to trade dynamics for the region. Luis started his career as an equity strategist at McGlinn Capital, a value-oriented asset manager in Pennsylvania. He holds an MS in Economics and a BA in Industrial Engineering from Lehigh University; he sits on the board of Lehigh’s Martindale Center for the Study of Private Enterprise and is a CFA charter holder.
Vincent Low
vincent.low@rohatyngroup.com
Vincent has over 30 years of experience in covering global macroeconomics and markets. He is responsible for formulating investment ideas with PMs, strategists, and equity analysts and developing macro investment themes and processes for TRG’s public markets business. Prior to rejoining TRG, where he was previously CEO of its Singapore office and an Executive Committee member, Vincent held the role of Advisor to the Economics Policy Group at the Monetary Authority of Singapore. He also held roles as the Head of Currency and Fixed Income Strategy at Merrill Lynch, and Senior Economist for Southeast Asia at J.P. Morgan and Standard Chartered Bank. Vincent started his career at the Monetary Authority of Singapore in 1987 and received a Bachelor of Social Sciences in Economics from the National University of Singapore.
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