Active Thinking: Emerging Markets - Underowned and undervalued

Ygal Sebban, Investment Director of Emerging Market Equity, explores the opportunities in emerging markets and explains why he believes investing in Chinese equities looks particularly appealing right now.

Why invest in emerging markets (EM)? We think there are strong secular and cyclical drivers that make them attractive.

Secular drivers are primarily related to demographics. EM have a growing population with a much younger demographic compared to developed markets (DM). For instance, by 2050, almost 28% of the population in DM will be over 65 years old vs only 15% in EM. Younger populations as well as urbanisation and increasing middle class and rising female participation will all be factors supporting consumption and thus growth. In EM, financial markets should also be supported by reform programmes including pension reforms.

Credit quality in EM has improved. Eight out of the top 10 EM countries are currently investment grade versus only four out of 10, 20 years ago. EM sovereign debt/GDP levels are well below half of the DM levels.

As we potentially face a period of slow growth at the end of an investment cycle, the growth differential between emerging and advanced economies is expected to widen. In a low-growth world, investors will seek out growth opportunities, which are more abundant in EM.

Emerging markets are historically cheap

Chart 1: MSCI Emerging Markets Index forward price-to-book (P/B) ratio – Premium or discount to S&P 500 Index

Source: GAM, Bloomberg, as at 30 September 2024. Indices cannot be purchased directly. Please see the disclaimers at the end of this material for important disclosures regarding the information contained herein.

EM have underperformed their DM counterparts dramatically over the past 10 years. Currently, we are at the bottom of a performance range when comparing the MSCI Emerging Markets Index (MSCI EM) to the S&P 500. In terms of valuation, EM have rarely been this cheap relative to DM equities, with EM trading at a discount of more than 40% compared to DM, as measured by the P/B ratio of the MSCI EM and the S&P 500. The forward 12-month price-to-earnings (P/E) ratio currently stands at 12.6x for MSCI EM compared to 21.2x for S&P 500.

Moreover, current high real interest rates in many EM (for example Brazil at about 7.6%, South Africa at 6.2%, Mexico at 5.2%) should be supportive for EM currencies and thus for future returns of EM equities.

Over the past 20 years, there has been a structural shift in the sectors within EM. Today, consumer discretionary and technology sectors (together about 37% of the index versus only 24% twenty years ago) play a much more prominent role compared to the past, moving away from the traditional focus on energy and materials (weight of 11% combined versus 22% twenty years ago).

Opportunities in China

Opportunities in China are particularly appealing at present due to the recent coordinated actions across monetary, fiscal, property and stock markets. At the end of September, China announced a new rate cut, a stronger fiscal policy with the potential issuance of another RMB 2 to 10 trillion in central government bonds, and measures to support the property market by decreasing mortgage rates and reducing down payments. China will go to the high range of the fiscal package in case Donald Trump wins the US presidential election to mitigate the negative impacts of higher tariff.

Additionally, Chinese authorities have embarked on substantial support to the stock market with a RMB 800 billion swap for institutions to buy equities and assisting companies with buybacks. This is not quantitative easing, but a strong measure where the People’s Bank of China (PBoC) takes on part of the risk by lending at favourable conditions to companies and institutions. This coordinated effort is a significant boost for both the economy and the stock market, and we expect more measures should follow.

We are confident that China will reach its 5% growth target for this year and that it will do whatever is necessary to support growth. In terms of support, some analysis suggests that the recent measures should add 40 basis points to GDP growth. While this may not seem substantial, it is significant. During the first half of this year, fiscal policy played a tightening role on the economy. In contrast, the second half of this year is seeing the opposite effect.

A potential new dawn

Many investors remain significantly underweight China. The China allocation in active funds and hedge funds globally is at an all-time low. Mutual funds globally had a 5.1% allocation in Chinese equities as of the end of August*. Retail investors, meanwhile had very little exposure to China because Chinese equities have been lagging significantly in recent years. However, since the September announcement, there was huge interest from retail investors to open new brokerage accounts and individual investors have been already started buying Chinese shares. Retail investors have only 6% of their financial assets invested in equities, compared to 46% in bank deposits. This is an encouraging signal, and we believe there is more to come.

Key themes

Our key theme in China is consumer discretionary; the Chinese consumer is expected to play a significant role in the macroeconomic landscape. The valuation of this sector looks appealing, with no significant premium relative to the market and at the bottom of the 5-year historical range, both in absolute and relative P/E terms compared to the Index, with a positive earnings revision trend seen in the last two years.

Household consumption accounts for about 38% of GDP in China, compared to much higher levels in other countries (almost 70% in the US, 50% in Germany, 60% in India etc.) and we expect the weight of consumption in GDP in China to increase in the coming years.

Chart 2: GDP per capita (Current US dollar) and household consumption percentage of GDP

Source: GAM, Bank of America Global Investment Strategy, World Bank, Bloomberg, as at October 2024. For FY24, the World Bank defines ‘upper middle income’ as USD 4,466 to USD 13,845 gross national income per income capita and ‘high income as above USD 13,845 gross national income per capita. The views are those of the manager and are subject to change.

Within this theme, we favour travel-related companies due to both positive trends and attractive valuations. We also like many internet companies, such as platforms and e-commerce. Companies like Meituan, a Chinese delivery and travel company or Trip.com, a travel service company, have positive earnings momentum and attractive valuations. BYD, a Chinese integrated electric vehicle (EV) company, is another interesting story. BYD and Tesla are running neck and neck in terms of EVs sales worldwide, but BYD produces lowest-end vehicles at more than 50% discount compared to Tesla's prices. It currently trades at about 17x forward P/E for 2025 compared to Tesla's 83x.

The view on India

However, despite the positive outlook, we believe the Indian stock market in general is expensive and we are underweight. We focus on valuation stories, especially around banks and telecommunications companies, which are growing rapidly and serve as digital banks for the unbanked population. We also focus on IPOs in India. We monitor IPOs closely and conduct thorough due diligence, participating from time to time.

Outlook

EM are under-owned and undervalued (forward 12-month P/E ratio of 12.6x versus 21.2x for the S&P 500), making them attractive investments in our opinion. We see strong secular opportunities driven by demographics, reforms and healthy economies.

The key themes we currently favour across EM are offshoring and nearshoring (particularly in banks and industrial properties) in Vietnam and Thailand, as well as leaders and undervalued beneficiaries of AI in the Asian technology space.

We also particularly like the Asian consumer sector, with many opportunities in China and the rest of Asia. Chinese equities are currently cheap (with the MSCI China Index currently trading at 9.5x next year’s earnings). We expect to see improving earnings momentum in the coming quarters when the impacts of the Chinese stimulus play out. Companies we favour are producing strong free cash flow yields, making them attractive investments in our view.

The key risk that we see is the volatility around potential tariff under a Trump administration. While the higher tariff would be negative on growth, especially in China, we believe that a lot of this is already priced into equities. We emphasise that the market cap-weighted export as a percentage of revenue was only 4% for the MSCI China Index in 2023**. We also believe that the negative impact of earnings related to higher tariffs will be mitigated by extra stimulus from the Chinese government. We would then consider a dip in the markets as a compelling entry point.

Ygal Sebban leads the Emerging Markets Equity team and manages the Emerging Markets Equity strategy at GAM Investments.

* Source: GAM, Bloomberg and Goldman Sachs, as at 26 Sep 2024.

* Source: JP Morgan.

Important disclosures and information

The information contained herein is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained herein may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information contained herein. Past performance is no indicator of current or future trends. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice or an invitation to invest in any GAM product or strategy. Reference to a security is not a recommendation to buy or sell that security. The securities listed were selected from the universe of securities covered by the portfolio managers to assist the reader in better understanding the themes presented. The securities included are not necessarily held by any portfolio or represent any recommendations by the portfolio managers. Specific investments described herein do not represent all investment decisions made by the manager. The reader should not assume that investment decisions identified and discussed were or will be profitable. Specific investment advice references provided herein are for illustrative purposes only and are not necessarily representative of investments that will be made in the future. No guarantee or representation is made that investment objectives will be achieved. The value of investments may go down as well as up. Investors could lose some or all of their investments.The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries. With 1,277 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI China Index captures large and mid-cap representation across China A shares, H shares, B shares, Red chips, P chips and foreign listings (eg ADRs). With 597 constituents, the index covers about 85% of this China equity universe. Currently, the index includes Large Cap A and Mid Cap A shares represented at 20% of their free float adjusted market capitalisation. The Standard and Poor's 500 Index, or simply the S&P 500, is a stock market index tracking the stock performance of 500 of the largest companies listed on stock exchanges in the United States. References to indexes and benchmarks are hypothetical illustrations of aggregate returns and do not reflect the performance of any actual investment. Investors cannot invest in indices which do not reflect the deduction of the investment manager’s fees or other trading expenses. Such indices are provided for illustrative purposes only. Indices are unmanaged and do not incur management fees, transaction costs or other expenses associated with an investment strategy. Therefore, comparisons to indices have limitations. There can be no assurance that a portfolio will match or outperform any particular index or benchmark.

The foregoing views contains forward-looking statements relating to the objectives, opportunities, and the future performance of the markets generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of GAM or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.

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