Markets are often influenced by heuristics, and in the emerging world the rule of thumb that dominates most is that when US interest rates are rising, emerging market assets are doomed to underperform, almost regardless of any other dynamic.
This is because, according to its advocates, EM economies and countries are required to borrow in dollars or other 'hard currencies', rather than in their own currency.
As US rates rise, this would be expected to lead to dollar strength, pushing up the debt repayment costs of corporates and countries in the merging world, leaving less cash for distribution to shareholders, or to reinvest in the economy.
In response to this, EM economies have historically raised their own interest rates to protect their currency relative to the dollar, dragging down the level of aggregate demand in economies.
Added to this is the notion that if US rates are rising, the likelihood is that global economic growth will slow down, prompting a retreat from risk assets, and with EMs hosting some of the highest beta asset classes, this has a negative impact for investors there, while the higher yield available on government bonds means there is less appeal to owning riskier equities, especially for an non-US investor who may benefit from the strength of the dollar in terms of the income they get from the bonds.
But does that rule of history apply in the world of today?
Guy Miller, chief economist and market strategist at Zurich, says one key difference this time is that many EM central banks, particularly in Latin America, actually lifted rates ahead of the US Federal Reserve, mitigating somewhat the impact of the US rises, while also potentially having the capacity to cut rates ahead of the Fed, and thereby stimulate economic growth.
EMs are generally in an enviable position relative to developed markets.Victoria Harling, Ninety OneAnuj Arora, head of EMs and Asia Pacific equities at JPMorgan Asset Management, says: “While markets have certainly been more volatile, there are reasons to be more optimistic about EM equities, including falling global inflation, which provides EM central banks room to cut aggressively, and a weaker US dollar.
"China’s economy continues to grow, though slower than expected. Valuations – currently around their long-term averages – are reasonable, and EM earnings offer upside potential.
"As always, we continue to look for opportunities in EM equities where earnings growth can compound over the long run."
Miller agrees that the dollar is likely to strengthen rather than weaken from here, as a consequence, in his view, of a deteriorating outlook for the US economy.
He believes inflation will fall in 2024, and as a consequence interest rates in the US will be cut by “the middle of next year”, which would be expected to lead to downward pressure on the dollar.
Victoria Harling, head of EM corporate debt at asset manager Ninety One, goes further, saying that while times of geo-political uncertainty such as we are currently experiencing would normally be expected to dent demand for EM assets, the capacity for those economies to cut rates gives them and advantage relative to developed markets.
“EMs are generally in an enviable position relative to developed markets,” she notes.
Her view is that monetary policy generally operates with a lag of between 12 and 18 months, so the rate cuts that many EM economies enacted in 2023 will, in her view, begin to drive growth in 2024.
The China conundrum
Miller says the EM equity index is dominated by Chinese stocks, so to an extent its the fate of that economy which will impact returns in the coming year.
He describes himself as “constructive” on the outlook for the Chinese economy, believing that some of the economic data is now showing signs of improvement.
Miller says: “The narrative has almost grown that China is uninvestible, and the truth is, you do need a risk premium to invest there. But my view is that an investor is getting that risk premium, especially as I think policymakers in China will stimulate the economy in 2024, which should help growth.”
The general backdrop for the EM asset class has been challenging in 2023.Ewan Thompson, LiontrustJPMorgan’s Arora says some of the reason for the bumps in the road experienced by the Chinese economy in recent years have been a function of it moving to a more “sustainable” growth model rather than be reliant on exporting goods.
He notes that Chinese consumers will have a better year in 2024 than they did in 2023, which he says will be positive for growth in that country.
As China has sought to move away from being the lowest cost manufacturer and towards a model with consumption more central to its approach, other Asian economies have taken up the baton as manufacturers.
Many of those economies are in the Asia Pacific region, and Miller says economic data appears to indicate that the downturn in demand for manufactured goods, which occurred globally as economies exited pandemic-era restrictions, appears to be easing and he anticipates the result being that those economies perform relatively well in 2024.
He adds: “I think chip prices have stabilised and we are at the start of a new technology cycle, which should also help those Asian countries.
Arora says: “From a North Asia perspective, the region’s tech-heavy focus looks increasingly well positioned, as the sector positions itself for the next decade’s big trends with, for example, structural demand for artificial intelligence, cloud adoption and electric vehicles.”
One of the Asian economies that has been displacing China as a manufacturing hub is Vietnam, but Ngo Thanh Thao, deputy portfolio manager of Vietnam Enterprise Investments, sees more value in investing in the domestic economy, in areas such as urbanisation and the growth of middle class consumers as a consequence of the manufacturing boom.
She adds that Vietnam has also been developing its relationships with the rest of the world and has a wide array of trade agreements in place.
Ewan Thompson, an EM investor at Liontrust, says: “The general backdrop for the EM asset class has been challenging in 2023 due to two key factors: the ongoing disappointment surrounding China's economic recovery after the abrupt shift away from zero-Covid; and the rapid increase in global interest rates in response to elevated inflation.
"While China performed poorly, however, several individual markets bucked this trend with strong returns, including Taiwan, South Korea, India, Brazil and Mexico.
"With EM valuations remaining depressed at a 25 per cent discount to developed markets and well below their own 10-year average, the asset class is well placed to benefit from returning capital flows as growth reaccelerates and interest rates fall.”
David Thorpe is investment editor at FT Adviser
