Will emerging market equities play catch-up?

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Emerging market stock indices have underperformed the broad equity rally this year. They’ve lagged behind not only American, Japanese and continental European equities, but even UK stocks. In sterling terms they’ve barely broken even.

With the Federal Reserve signalling that it is probably done in raising interest rates, and the bond market pricing in a series of cuts next year, it feels right to ask whether it’s time for emerging markets to play catch-up.

Lumping together firms listed across such a disparate collection of geographies can look lazy at best. Emerging nation equity markets vary in their politics, economic challenges and institutional arrangements. Turkey is a long way from Taiwan in many ways. Collectively, they tend to do well when the US dollar is weakening, the global rates outlook is benign, the world economy is growing briskly and international trade volumes are increasing. But what unites them beyond MSCI index taxonomy is the importance of country-level macro risk factors to their performance.

China makes up almost 30 per cent of the market and its very public property bust has hit the domestic economy hard. Regulatory uncertainty continues to haunt equity managers after the crackdown on technology and education companies.

Furthermore, the international picture is difficult for China. Since Trump introduced waves of tariffs on a range of Chinese imports in 2018, its share of US goods imports has decreased by around a third, relegating it to behind Mexico as source of imported goods. Trading at less than 10 times next year’s expected earnings, Chinese stocks are cheap for a reason.

By contrast, the next largest markets — India and Taiwan — rank among the most highly valued in the emerging universe. India is enjoying a domestic boom. According to the IMF, the rollout of the “India Stack” — a government-backed digital payments initiative — has boosted tax receipts by bringing a host of activities into the formal economy, and led to a huge expansion of financial services. The government has also maintained large fiscal deficits and farmed its tax windfall back into the economy in the form of public investment.

Infrastructure is being upgraded and foreign companies welcomed. More than one in five JPMorgan and Goldman Sachs employees now work in often-gleaming new Indian campuses. But accessing this structural growth story comes at a cost. Priced at more than 22 times next year’s expected earnings, India is now the most highly valued major equity market in the world.

Taiwanese market returns, like those of South Korea, have been flattered by the global tech boom: tech stocks account for more than 70 per cent and around half of their markets’ capitalisations, respectively. TSMC, the world’s largest contract chipmaker, alone accounts for more than 40 per cent of the Taiwanese market. Future returns will be intimately tied to the fortunes of the global chip market, absent local geopolitical flashpoints.

Away from Asia, returns have been generally good. Strong markets in Brazil and Mexico have delivered handsome returns. But EM Advisors, a specialist research boutique, warns that with Brazilian interest rates substantially above nominal gross domestic product growth and the economy falling into recession, headwinds are building for company earnings and fiscal authorities. Some eastern Europe markets have delivered spectacularly, but they only have tiny index weights.

While asset allocators often spend more time thinking about geopolitics than is ultimately warranted, 2024 presents an electoral labyrinth. The most important election for emerging equities will be the US presidential poll in November, the result of which has the potential to destabilise every market. Beyond this, countries accounting for more than half the market cap of the MSCI Emerging Market index will see general elections — no mean feat considering that autocracies account for almost 35 per cent of the index.

Votes in Indonesia and South Korea don’t look as if they carry much potential for significant market impact. In India, Modi’s re-election is all but assured, and the African National Congress is unlikely to lose outright in South Africa. Claudia Sheinbaum, President Andrés Manuel Lopez-Obrador’s preferred candidate, leads the polls by a huge margin in Mexico. But Taiwan’s general election in January looks much harder to call. And given the global importance of cross-straits relations, its outcome has broader ramifications.

Global equity valuations are on the rich side of their post-1990 average. Offered at less than 12 times expected earnings, emerging equity market valuations by contrast are cheap to their own history. The consensus for a benign global bond market outlook and soft landing make the valuation case tempting.

But hot wars in Europe and the Middle East, and a congested electoral calendar, warrant some geopolitical risk premium. And with the global economy softening and trade volumes falling, putting money into the market on a catch-up trade looks unnecessarily speculative.