Opportunities outweighing risks in emerging markets

What are the prospects for emerging-market fixed-income and equity investments in 2024 and beyond?

Factors such as the higher-for-longer interest-rate environment, national elections and restrictive regulatory frameworks have combined to create challenging conditions for investors in emerging markets in 2024. However, despite these issues, there are a number of reasons for optimism in both fixed income and equities.

The prospect of interest rates remaining elevated for the foreseeable future is not necessarily bad news for sovereign debt in emerging-market economies. Looking at the higher-rated countries, most are net external creditors: that is, they have greater levels of dollar-denominated assets than dollar-denominated debt. They tend to have very long duration debt – so they only need to refinance a small proportion of their overall debt at today’s higher rates. Over the past two years, we have only seen significant increases in risk premiums on the lowest-rated debt, with premiums on higher-rated sovereign debt remaining largely unaffected.

Our constructive view on this asset class was further strengthened by a stress-test analysis that we carried out in 2023: this found a low probability of default among emerging-market countries in the event they had no access to debt markets for two years.

This analysis is complemented by the fact that policymaking in distressed countries has improved considerably in recent years, to the extent that it is now far easier for politicians to say they have little choice but to implement potentially unpopular fiscal policies due to the requirements imposed by the International Monetary Fund (IMF). At the same time, these nations have benefited from the availability of cheaper funding from the likes of the IMF and the World Bank.

As well as monetary policy in the US, China’s economic performance tends to have a significant impact on emerging markets. In emerging-market fixed-income, around 60% of countries are commodity exporters that in the past have been vulnerable to slowing growth in China. However, since the Covid-19 pandemic, we have seen commodity prices rise despite difficulties in the Chinese economy. This has been for two reasons: first, a general lack of investment in commodities has led to a reduction in supply, and second, increasing levels of decarbonisation have driven rises in demand for the metals and minerals needed in technology such as solar panels and electric vehicles.

This year, we have already seen new debt issues oversubscribed and performing well in the secondary market: this is usually a precursor of money coming into emerging-market funds. Meanwhile, yields remain notably attractive relative to historical levels. Taken together, these factors mean there is a significant return opportunity in this asset class at present.

While fixed-income investing in emerging markets is more of a bet on a nation’s performance in exports, equity investments are geared to a much greater degree to domestic growth. Therefore, emerging-market equities have been a huge disappointment on the whole over the past decade. But looking at the major economies individually gives a better idea of what factors may be able to support returns in the years ahead. Emerging markets are not homogenous, and an active investment approach can help investors to take advantage of opportunities as and when they arise.

China has underperformed in recent years due to a number of problems, including the risk of sanctions, regulatory interference and problems among the country’s real-estate companies. We believe the authorities have taken the right measures to stabilise the latter sector. However, a more general issue is that, despite high retail and corporate savings ratios, there has been a lack of investment because of low confidence levels – for example, there is a lot of uncertainty around the regulatory framework in China. Chinese companies are adapting though: for example, the threat of sanctions has led many to set up facilities elsewhere in the region.

The situation in India is brighter. While the outcome of the recent election created an element of uncertainty, we believe the overall impact will be positive. According to our forecasts, India’s growth over the next decade should be around 5% to 6% a year, which could make even some of today’s expensive-looking companies appear attractive and help the Indian market to extend its recent period of outperformance.

South Korea, meanwhile, is arguably the most undervalued stock market in the world, with 78% of companies trading below book value. One of the main reasons for this is the restriction that currently applies to dividend payments, which has resulted in many companies simply sitting on cash rather than returning it to shareholders. We believe the authorities in Korea will follow Japan’s example and relax this policy to some extent, a development that has the potential to raise the valuation of the corporate sector over the next five to 10 years.

Recent elections in Mexico also created uncertainty and led initially to a sharp fall in the stock market. However, there are signs that the policies pursued by the new left-wing government may not be as drastic as suggested during the election campaign.

In secular terms, emerging markets have significant exposure to semiconductors and artificial intelligence (AI), in particular in Korea, Taiwan and China. Businesses such as Taiwan Semiconductor Manufacturing Company and SK Hynix in Korea play vital roles in the supply and production of components needed by AI applications and have seen their valuations increase sharply in recent months.

Clearly, there remain a number of challenges in emerging markets, but performance so far this year has been strong, and valuations still appear attractive. One final positive is that the authorities in many emerging nations are changing their approach to the corporate sector and focusing on trying to make their respective markets more valuable. This is a highly supportive trend that we expect to see play out over the next few years.