THE THAW IN EMERGING MARKETS, AT LAST?

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Weekly

May 13, 2024

Emerging markets outperformed in April, driven by China

Technical indicators offer interesting short-term support

Fundamentals will reinforce this positive long-term trend

When an upturn occurs, the first wave is usually the most rewarding

CHART OF THE WEEK: "In relative terms, emerging indices seem to be bottoming out"

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FINANCIAL MARKET ANALYSIS

After a long stock market winter between 2021 and 2023, the emerging markets seem to be showing signs of life. Their benchmark index, the MSCI Emerging Markets, is up 11%, compared with 9% for the MSCI World All Countries (see Fig. 2). This outperformance was achieved very recently, in the last few weeks of trading. Technically, the index has just passed a key milestone. By overcoming strong resistance at $1,063, it has paved the way for significant gains (see Fig. 3). That was all it took for investors to see an opportunity.

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2 Fig. 2 - Equity markets: global vs. emerging - Fig. 3 - Technical analysis of emerging markets

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As good news never comes alone, a number of fundamental factors are whetting investor appetite for emerging markets:

▪ The outlook for growth is improving all the time inflation is under control (see Figs. 4 & 5). In India, for example, strong domestic demand, coupled with an increase in exports, has supported economic activity. Mexico, meanwhile, has managed to keep inflation below 5% thanks to a rigorous monetary policy between 2021 and 2023.

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Fig. 4 - Business outlook: DM vs EM - Fig. 5 - Inflation rate: DM vs EM

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▪ Lower interest rates. In many emerging countries, central banks have already begun the process of easing their monetary policy. This is particularly the case in China, where the reserve requirement ratio (RRR), which represents the proportion of deposits that banks must keep in their vaults, has been cut from 12.5% to 10%. The latest boost came at the end of January. These favourable credit 3 conditions are encouraging companies to deploy capital and hire more staff. Similarly, households tend to consume rather than save.

▪ Anticipation of a weakening dollar. Historically, when the greenback depreciates, emerging markets outperform (see Fig. 6). Now, as US employment figures deteriorate (see WIF of 6 May 2024), investors will be expecting US yields and therefore the dollar to fall. For the record, our econometric estimates point to a 12% fall in the greenback in 18 months' time, when the interest rate differential will no longer be so positive.

▪ Valuations are very attractive. For example, the ratio between the price/earnings ratio of the emerging markets index is 13.7x, well below that of the developed markets index (21.1x), even considering the historical discount (see Fig. 7).

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Fig. 6 – EM relative performance vs US dollar - Fig. 7 - Equity valuation: EM vs DM

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Among the emerging markets, China accounts for more than a quarter. It's hard to do without it. Next come India and Taiwan at 18%, followed by South Korea at 12% (see Fig. 8). Of the remaining countries, only Brazil manages to be significantly visible at 5%. Interestingly, the technology and communication services sectors are very well represented, with 23% and 9% of the basket respectively. Unlike in the past, investing in emerging markets no longer means buying only financials and energy stocks. Contrary to preconceived ideas, emerging markets offer exposure to the most promising themes. The top three companies in the MSCI Emerging Markets index are TSMC, Tencent and Samsung, accounting for 16% of the index.

Among the emerging countries, investors regularly seek to trade off China against India, or vice versa. Having favoured India in recent times, they are now turning their attention back to China:

▪ Capital flows into the Indian market have been excessive, making it too expensive, not to say speculative (see Fig. 9). Conversely, Chinese equities are suffering from investor mistrust. They legitimately fear 4 excessive government interference in the economy, which is hampering free competition and the market economy. Under this pretext, Chinese indices have become excessively cheap.

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Fig. 8 - Composition of the MSCI Emerging Markets index

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▪ The Middle Kingdom is showing signs of recovery. Despite the fact that the outlook has been disappointing since the end of the pandemic, government stimulus measures are supporting activity. In particular, investors are expecting to see a positive impact on corporate profits from household consumption and tourism. The economic signals seem to be pointing in this direction, with the latest Gross Domestic Product (GDP) showing relatively solid annual growth of 5.3% in the first quarter, and the leading indicators back in the expansion zone (see Fig. 10). It is therefore quite logical that China should be the emerging country with the best stock market performance in April.

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Fig. 9 - Equity valuations: China vs India - Fig. 10 - Economic activity in China

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Conclusion :

After several years of poor performance, emerging markets, and more specifically China, appear to be on the verge of a historic upturn (see Chart of the Week). Several factors are underpinning this trend reversal: economic recovery, contained inflation, a weak dollar, attractive valuations, and favourable technical indicators. Of course, there is a risk of a false start, but missing the first wave of outperformance often proves costly, as it is the most lucrative.

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