The fortunes of EM equities are expected to change for the better as the possibility of the recent cycle of underperformance nears its end.
Despite lacklustre investor sentiment towards the asset class in recent years and a lag compared with developed market stocks, especially the US, exposure to a diverse opportunity set at undemanding valuations bodes well for EM.
“We strongly believe that the current cycle of underperformance could be coming to an end and the tide could well turn back towards EM,” said Michael Bourke, global EM team head and portfolio manager at M&G Investments.
The UK fund house believes that improving fundamentals, better corporate behaviour and attractive relative valuations – the dynamics to fuel this re-evaluation – are already well underway and are becoming better understood by investors.
Behavioural change
Erratic and generally weak corporate profitability in many EM has been a recent deterrent for a lot of investors. They have also seen a higher risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks compared with developed markets – creating potential difficulties in buying, selling, safekeeping or valuing investments in EM.
However, Bourke is now seeing greater capital discipline among EM firms when investing in new projects and a sharper focus on delivering returns to shareholders in the form of dividends and share buybacks.
As a result, he forecasts a shift in the return profile of EM corporates, across state-owned companies, conglomerates and private firms.
“We are encouraged by this improvement in capital allocation and balance sheet behaviour and remain optimistic that it can help EM equities close the gap with developed market stocks,” he explained.
Currency resilience
The past 12 months or so have also seen a change from the historical vulnerability of EM to US interest rate cycles which, in the past, led to outflows and sharp dislocations in EM asset prices.
But now, EM are arguably in a better position to cope with US rate hikes.
Latin American currencies, in particular, have been strong performers. “Central banks in the region had to react swiftly to the prospect of inflation being passed through to their economies from the Covid-related stimulus being introduced in the West,” said Bourke.
Aggressive rate hikes in these countries ensured their currencies have remained resilient. “They are benefiting now as inflation is abating, enabling central banks to consider cutting rates, ahead of their developed market counterparts,” he added.
Improving fundamentals
In addition to a more favourable macroeconomic environment, encouraging trends at the company level could also benefit EM equities.
In contrast to the two dramatic falls in EM company earnings in the past decade, profitability in 2022 sabilised quicker than many market participants expected, also partly driven by changes in corporate behaviour.
“EM market firms have realised the days of easy growth are over and, in our opinion, are, by and large, becoming more professional and starting to understand the importance of using capital efficiently,” said Bourke.
“In our view, these positive developments are not fully understood and support a more optimistic outlook for the asset class,” he added.
Appealing valuations
Further, across many metrics, M&G Investments considers EM equities to be cheap in relative terms compared with global and US equities.
This can be explained by the fact that many investors often focus on China as the dominant market in EM, yet the asset class as a whole offers access to a large number of interesting opportunities.
“EM equities are not a homogeneous asset class,” said Bourke. “They comprise many distinctive economies, with different drivers and features. And that is before you consider the enormous spectrum of companies that can be found across the entire global investment universe.”
He points to the Asean region’s characteristics as looking interesting at the moment. Markets like Vietnam and Malaysia, for example, are benefiting from companies moving their supply chains away from China. Indonesia is also attractive, as a large commodity producing nation with favourable demographics that could boost economic growth.
Elsewhere in the world, Bourke says Mexico is also benefiting from nearshoring given its proximity to the US, with demand for commercial real estate very strong. And Brazil, another commodity-heavy economy, offers some of the best run companies in the world with high corporate governance standards, he explained.
