For most of my 30-year career, many investors viewed emerging market (EM) equities as a beta play on the global economic cycle. Money aggressively moved into EM in environments where global industrial production, trade, and growth were good and then retreated when the US Federal Reserve (Fed), for whatever reason, needed to tighten. Following that formula, one would have expected that the Fed’s massive monetary policy response over the past year to address high levels of inflation in the US would lead to a big emerging market economic crisis, falling currencies, and collapsing equity markets. That has not happened this time.
I think what has fundamentally changed is that EM assets have largely been neglected for the past decade. The lack of hot money meant that there was no creation of bubbles (though China might be in a slightly different phase) in terms of credit, current account deficits, or other imbalances that tend to pop up when EM is in favor. In fact, most emerging market economies, including classically volatile circumstances like Brazil, are actually sitting on very healthy external accounts; there hasn’t been a large amount of domestic credit growth in excess of nominal gross domestic product (GDP); and we haven’t seen ballooning asset levels. So, EM equities have evolved from being the world’s beta play to offering slower growing but more resilient economies. Coupled with attractive valuations, we believe that creates a very compelling investment opportunity for active investors.
Three catalysts that could favor EM equities
I think emerging market equity valuations look extraordinarily attractive on a relative basis, and I see a few catalysts that could crystalize that value.
- One is an improving growth backdrop. Many EM central banks have been well ahead of the US Fed in tackling inflation with monetary policy tightening. These economies have borne the adverse effect of high real rates for well over a year, resulting in decelerating economic and corporate growth, and weak asset prices. As inflation peaks, they should be the first to cut, and it is possible to see a scenario where growth accelerates in EM, both earnings and GDP, at the same time that it decelerates, or stagnates, in the developed world.
- Another positive could be a weaker US dollar environment, which would obviously be quite favorable for non-dollar assets. I’m actually quite bearish on the US dollar. The US has significant imbalances (the fiscal position is grim and getting worse), there is a structural current account deficit, and asset prices appear poised to retreat. Additionally, global central banks continue to diversify their reserves away from the dollar (this is one of the reasons gold has been so strong of late) and we’re seeing growing calls to conduct trade in local currency as opposed to the US dollar. None of this means that the dollar will be sidelined anytime soon, but the trend is clear.
- Finally, when you think about the biggest winner in the past decade, it has largely been US assets. We believe that level of outperformance is unsustainable, and valuations appear stretched. Within the US (and to be fair, globally) the winners of the past decade were long duration assets that benefited from a very cheap cost of capital – think real estate, private equity, technology and other beta plays. In a rising rate environment, where valuations and fundamentals begin to matter again, beta/momentum investing becomes very challenging – this bodes well for high quality EM assets.
Additionally, the world is a more complicated place with the frictions of geopolitical tensions, changing domestic policies, the ramifications of the energy transition, and deglobalization. In our view, successfully navigating these changes requires active managers who focus on generating idiosyncratic alpha.
Credits: Mr. Justin Leverenz