Emerging Markets: Reasons for Warming Optimism

Emerging markets (EM) have substantially underperformed developed markets (DM), particularly the United States, since the global financial crisis in 2008. However, we believe this underperformance may be changing, and that EM investing can offer important diversification benefits and return opportunities.

The historical underperformance reflects several factors, including economic growth disparities; more supportive monetary policy (including quantitative easing) in the US; a stronger US dollar despite that monetary policy stance; commodity price volatility coupled with a period of high capital spending; and heightened geopolitical and other risks. As a result, investors have reduced their EM allocations to near all-time lows, remaining underinvested in EM and with disproportionate exposure to US equities.  The global willingness to invest in EM equities remains tepid thus far, but the outlook now appears encouraging for the asset class for several reasons.

Improving Economic Growth Premium

Emerging markets on average exhibit higher economic growth rates compared to developed counterparts, but the EM premium on growth rates varies over time.  After reaching a low point during the COVID-19 pandemic, the economic growth premium has improved as EM economic growth is accelerating while the developed world is moderating. EM real GDP growth, moreover, is not solely driven by China; countries like India, the Philippines, and Indonesia are expected to grow between 5 percent and 7 percent this year.  

Earnings Growth Reacceleration

Earnings follow a similar pattern to relative economic growth: following a sharp decline throughout 2021 and 2022, earnings growth expectations for EM have risen and are projected to surpass those for DM, including the US, this year and next. Historically, stronger earnings growth has driven outperformance of EM over DM equities.

An acceleration in earnings momentum within EM could be a tailwind for relative performance. Admittedly, geopolitical factors in the Middle East, in Russia and Ukraine, and in the South China Sea could act as headwinds.

Attractive Valuations

EM valuations remain inexpensive compared to DM equities.  Absolute valuation levels have risen since their lows in Q4 last year, but EM valuations relative to DM equities still suggest potential upside.

On a forward price-to-earnings multiple, EM is trading at 12.6x, compared to 18.9x for DM (MSCI World Index) and 21.6x for the US.

The 20-year average EM discount to DM and US equities is 21 percent and 25 percent, respectively, but current discounts exceed these averages at more than 30 percent and 40 percent.

Over time, these valuation discounts may narrow due to stronger earnings growth in EM, recovering profitability (which is currently underway across a wide swath of markets and sectors), attractive free cash flow and dividend yields, and a widening economic growth premium in EM’s favor. This presents an opportunity for investors to enter these markets at lower prices, potentially leading to higher returns as assets appreciate.

Global Monetary Easing

The effect of the exchange rate could also favor EM equities, though this depends in part on policy in the United States.  A tempering of dollar strength, or even dollar weakness, as occurred during 2016–2018, could further support the outlook for emerging markets’ earnings growth.

The Federal Reserve’s easing cycle, which began with the first cut on September 18, should create a more supportive environment for EM assets through a moderation in US dollar strength. Historically, EM assets have enjoyed some of their strongest years of outperformance following a peak in the US federal funds rate and strong risk-adjusted returns after global rate-cut cycles commence.  One complicating factor is that substantial tariffs in the United States could push the dollar stronger, and the pace of Federal Reserve easing may also be affected by inflation dynamics that may be influenced by changes in tariffs, tax policy, and immigration policies.

Long-Term Demographic Trends

Developed markets face aging populations and declining working-age participants, while EM generally enjoys a demographic tailwind with larger young populations and lower dependency ratios. For example, nearly 80 percent of India's population is younger than 50, positioning it to benefit from a demographic dividend.

Diversification from US Equities

Apart from the potential for more promising returns going forward, investors seeking to diversify their portfolios across different economies and regions, and guard against a risk of valuation derating in US equities, may consider adding EM equities to their portfolios. Emerging markets can offer investors exposure to new industries and sectors, such as infrastructure development, increasing domestic consumption, and export growth, which may be underrepresented or unavailable in developed markets.

Low Investor Positioning

EM remains an under-owned asset class. A reversion to the 20-year average allocation of 8.4 percent of global portfolios would represent inflows of $910 billion, or about 58 percent of current EM assets under management.

Conclusion

Several factors suggest EM equities may be more attractive going forward than they were over the past 15 years.  Despite the potential benefits, however, investing in EM can be precarious (e.g., political and regulatory risk, currency risk, liquidity risk, corporate governance risk).  For many investors, an active approach could therefore make the most sense to investing in the asset class.

By Peter Orszag , James Donald and David Jauregui