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Three drivers of growth and profitability in emerging markets
Earnings growth is set to become a key driver of EM equities returns in 2025. Guido Giammattei, EM Equity Portfolio Manager, looks at three key structural and cyclical drivers for a change in the EPS growth and profitability profile of the asset class.
Key takeaways
- China RoE recovery: China RoE bottomed in 2022, and a recovery since then gathered pace in 2024, driven by better net margin and asset turnover. We believe this is supported by a more benign regulatory environment, lower excess capacity, and a recovery in consumption.
- Monetary policy easing: inflation has normalised, and many EM countries are expected to start or will continue to cut rates in 2025. Lower inflation and rates are supportive to a recovery in consumption.
- Global investments in technology: EM hosts the majority of IT and AI supply chains, and will continue to benefit from rising investments in technology. The sector is likely to continue to be supported by strong earnings delivery.
China RoE recovery
Despite macro headwinds, Chinese corporates delivered a strong 26% EPS growth in 2024, the third strongest among EM. Expectations are for EPS to grow another 15% in 2025, as the EPS recovery broadens out from internet and tech companies to industrials and consumer names1.
The underlying factor supporting this growth is a recovery in China RoE. This bottomed between 2021-2022 and made a strong recovery in 2024. The improvement has been driven by excess capacity normalisation across most industries, including property, and better asset turn, driven by improved consumption and regulatory environments.
The Chinese government has lately stepped up the game in terms of policy announcements and measures to support the economy and reach the 5% GDP growth target. One key difference from prior measures taken by the government is that the new measures are increasingly directed at the consumer and property markets, deviating from the usual playbook of pouring funds into infrastructure projects, aggravating an already rather large excess supply issue. Government subsidies to consumers and the low level of consumption as a % of GDP in China should support a continuation of the recovery that started in the last few quarters.
Meanwhile, strong EPS growth and RoE recovery continues to support a strong valuation case for Chinese equities. Despite better equity performance in recent months, valuations remain attractive and investor positioning remains low.
Monetary easing
One of the key drivers of growth for EM economies in 2025 is expected to come from a recovery in domestic consumption. This is the result of two factors: lower inflation and lower rates. Inflation has halved in EM from its peak in 2022 but real wage growth has remained very robust. Average real wage growth in EM was 7.5% in 2024, and it is expected to remain strong at 4.0% in 20252.
The latter dynamic, coupled with low unemployment, supports a benign environment for consumer spending. Virtually all EM central banks should cut rates in 2025. Mexico, Colombia, Central Europe, Saudi, and Turkey are expected to see the deepest cuts, while Taiwan, South Korea, the Philippines, Indonesia, Thailand, and South Africa are expected to remain cautious with more modest cuts. Only two EM countries are expected to hold off from cutting rates: Malaysia, given its strong growth outlook, and Brazil, where the combination of strong growth, a weak currency, and stubborn inflation have led the central bank to perform a U-turn and move from cutting rates earlier in 2024 to raising rates.
AI and EM tech
While US companies are typically thought of as key AI beneficiaries, what is often overlooked is the fact that the bulk of the tech and AI supply chain sit in EM, in countries such as Taiwan, South Korea, and China. This area has become an important structural driver of earnings growth and equity performance for the asset class, and the weight of the IT sector in EM has been consistently increasing from high single digits two decades ago to currently one-third of the index.
As a result of this higher weight and the structural tailwinds supporting technology, the sector has become one of the major contributors to EM earnings growth. It recorded a strong 27% EPS growth in 2024 and is expected to deliver another strong year with a 24% EPS growth in 20253.
From a structural aspect, two elements underpin a positive view on this sector in EM: one is related to demand, and the other to the favourable existing market structure and its sustainability. Demand for semiconductors has fundamentally shifted. Smartphones, tablets, PCs, and other consumer gadgets accounted for most of the demand over the past decade. Now, the majority of this demand growth is driven by servers (hyperscale and cloud), HPC, and, in the last 1.5 years, AI. Tech products have become more complex to produce, with shorter product lifecycles and higher capital requirements, resulting in consolidated market structures. For example, in the Taiwan IT sector, which accounts for around two-thirds of the IT sector in EM, the RoE and operating profit margin, albeit already in a growing trend, have seen a marked increase upwards in the last 3-4 years.
In terms of market structure, Taiwan produced 92% of cutting-edge chips in 2024, while South Korea produced approximately 80% of the world's memory supply. If we extend the analysis to the best possible, to the whole global AI supply chain, we find that circa 40% is based in EM, across Taiwan, South Korea, Malaysia, and China4.
This part of the EM universe offers exposure to the IT sector and to the AI supply chain at more attractive valuation than in developed markets.
1 Bloomberg, MSCI, January 2025.
2 HSBC, January 2025.
3 UBS, Ibes, MSCI, January 2025.
4 RBC, Factset, UBS, January 2025.
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