Hiding in plain sight: have emerging markets been overlooked for too long?

Key takeaways

• EM is home to a diverse range of high-quality companies offering deep long-term growth potential, but broader underperformance and volatility have masked these opportunities for many institutional investors.
• We believe both EME and EMD are poised to benefit from improved fundamentals and continued market maturation.
• Historically, EMD has generated double-digit returns in the one-year period following the Fed’s first rate cut, outperforming equities and other fixed-income asset classes.

The past decade hasn’t always been kind to emerging-market (EM) investors. Broad index returns for EM equity (EME), for example, have significantly lagged the exceptional performance of U.S. assets, leading global asset allocators to purge their positioning and pushing valuations and expectations for EM assets to historically low levels. As a result, we believe investors are missing out on a compelling but underrecognized investment opportunity.

Behind the lackluster headline numbers—often skewed by China—lies a host of individual success stories from a diverse range of markets and industries driven by the accelerating pace of technological transformation and structural reform. These changes are being realized through the alignment of several long-term trends that are by now widely acknowledged, but bear repeating here:

Changing demographics: Many of these geographies have a young, working-age population with growing levels of disposable income. It’s forecast that 160 million people will be added to the middle class every year in the next decade, mostly in India and China, and that Asia is expected to account for half of global consumption growth in the next decade, equivalent to a US$10 trillion opportunity.

Transformative technology: Asia has long been the manufacturing base for the world’s high-tech equipment and components such as smartphones and semiconductors and that’s set to continue and expand with the growth of AI. Ongoing investment in research and development has generated significant intellectual property, enabling companies to capture an increasing share of overall value. China alone was responsible for 46.8% of all intellectual property applications in 2022.

Structural shifts: Once dominated by commodities-oriented, extractive industries, modern EM economies are far more than that: They’ve diversified to encompass a much broader range of industries and higher-margin goods and services.

In our view, EM presents a significant opportunity for institutional investors positioned to take advantage of the intersection of long- and short-term macro and fundamental drivers currently at play. It’s important to point out, however, that given the broad range of regimes, economies, and companies that make up EM, we believe an active approach is paramount when identifying high-quality companies with long-term growth potential. Similarly, as a global asset manager with more than a century of on-the-ground experience in Asia, we’re keenly aware of the value of investment professionals with deep local expertise.

EM equity: quality growth opportunities for the skilled stock picker

The key to reframing our view of EM performance is to recognize that the asset class is far from a single homogenous block. The case for EME isn’t simply a story about China, but one that encapsulates an ever wider cross section of themes and opportunities.

This is a diverse asset class with multiple, changing drivers among a range of countries at varying stages of economic, political, institutional, and social evolution. Identifying winning countries and companies can yield strong returns, making the analysis of the structural themes driving domestic economies a critical step in fundamental research.

At a company level, quality businesses can emerge stronger than ever from periods of stress. Conversely, the elevated interest-rate environment has brutally exposed overstretched balance sheets, overcapacity, and businesses facing structural decline or lack of profitability. Winners and losers can change places rapidly, further highlighting the importance of stock picking and on-the-ground sources of intelligence to inform early rotation when business models falter.

India: a country in metamorphosis

In terms of long-term regional and thematic opportunity, India and leading-edge technology stand out. We believe the rise of India over the last decade will continue to offer the best structural growth story in EM, with the transformation of old India to new India taking place before our eyes.

India boasts the highest forecast GDP growth in the world among major economies over the next five years and is estimated to drive one-fifth of global growth, becoming the world’s third-largest economy by the end of the decade. This is underpinned by a virtuous circle of healthy demographics, a far-sighted, committed reform agenda, the formalization and digitalization of the economy, an accelerating capex cycle, and the development of an extensive manufacturing and IT services-based ecosystem.

China: an active approach increasingly important in a mature market

While deflationary challenges and a property market downturn have led to huge underperformance since its February 2021 peak, China remains a core element of EM, albeit one now exhibiting mature market and low growth characteristics. Today, it’s a bottom-up, stock pickers’ market with attractive long-term risk/reward profiles among astutely managed businesses such as select, highly scalable internet firms addressing pent-up demand and unmet consumer needs. China remains a sleeping giant and if the government can successfully improve economic growth, the upside potential from today’s valuations would be significant. The 16% rally in the CSI 300 following the raft of economic support policies announced at the end of September is a case in point.

Latin America: diversified markets ripe for disruption

Further diversification potential lies in Latin America. While more exposed to commodities, cyclical industries, and external trade, these economies are also beneficiaries of structural reforms and, as a result of ongoing tensions between China and the United States, more extensive supply chains and near shoring, all of which support business growth and consumption. Both Brazil and Mexico are ripe for disruption, with the business models of new fintech and online retail businesses such as Mercado Libre accelerating fast as, unburdened by legacy technology and structures, they rise to meet unmet consumer needs long ignored by incumbents.

Funding the future: opportunities in EMD

The rapid economic growth across EM has been paralleled by the emergence of sizable capital markets. In the past decade, Asia's share in global capital markets has more than doubled, reaching nearly US$50 trillion in total nominal size. This growth is reflected in the insatiable demand for borrowing from both governments and corporations, especially in the fixed-income market, to fund broad-based economic transformation. The annual issuance volume of bonds in Asia has surged dramatically over the past two decades and is expected to continue playing a pivotal role in financing the region's future growth. India offers a prime example: In May, S&P Global Ratings revised its outlook on the country from stable to positive to reflect its view that “continued policy stability, deepening economic reforms, and high infrastructure investment will sustain long-term growth prospects.” Shortly after, Indian government bonds were added to the widely tracked JPMorgan Government Bond Index-Emerging Markets, potentially unlocking access to billions of dollars of inflows to help finance its current account and fiscal deficits.

By focusing on these dynamic and evolving markets, investors can position themselves to harness the significant growth and diversification opportunities that EM offers.

EMD and the impact of U.S. Federal Reserve rate cuts

Historically, EM debt (EMD) has generated double-digit returns on average in the one-year period following the U.S. Federal Reserve’s (Fed’s) first U.S. rate cut, outperforming equities and other fixed-income asset classes. With the Fed announcing a 50 basis point cut at its September 18 FOMC meeting, we see the immediate-term case for EMD as being particularly strong.

Analyzing previous first rate cuts, there are several factors that we believe are responsible for driving this result in the past, including yield, duration, accommodative financing mechanisms, and growth characteristics. Looking at today’s economic environment, we believe the stars are aligned for a similar period of outperformance for EMD in the near term.

Higher yields

EMD frequently generates more income relative to other income-producing securities with similar spreads but shorter maturities. Consider these comparative yields as of early July 2024:

Longer duration

Duration measures price sensitivity to changes in interest rates, and EMD’s longer duration profile will benefit the asset class during periods of falling interest rates. Here is a simple comparison of duration, which is measured in years, as of early July:

Accommodative international framework

EM countries can frequently access additional sources of external funding through multinational development banks and other foreign governments. For example, as a response to the COVID-19 pandemic, the International Monetary Fund stood ready to mobilize US$1 trillion to support developing nations.

Higher growth rates

EM countries tend to have stronger growth outlooks and better debt ratios compared with developed-market economies. This can potentially benefit aggregate EM performance both by helping insulate against the direct impact of a slowdown in the U.S. economy and by diversifying exposures across different EM economies.

EM offers a long runway for active investors

It’s genuinely rare to witness an investment opportunity supported by both long-term structural and near-term cyclical factors, but that’s exactly what we’re seeing today within the EM asset classes. Across both equity and debt, issuers in these markets are enjoying strong fundamental foundations and demographic tailwinds, combined with deep valuation discounts, rising earnings momentum, and policy rate inflection points that bode well for asset values.

EM can shape the future of the world and will increasingly command the attention of global asset allocators. By taking an active approach and leveraging local expertise, investors can unlock significant opportunities across emerging markets, capitalizing on both broad trends and specific, high-potential investments.