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EM equities: when challenges become opportunities
After a period of underperformance, EM equities have started to perform better relative to DM equities. Phil Langham, Senior Portfolio Manager and Head of our EM Equities Team, looks at whether this improved performance can be sustained, and the main drivers.
Key takeaways
- EM equities remain underowned and undervalued; we forecast a volatile period in the aftermath of the U.S. election.
- However, over the coming year, we have a positive outlook on both the absolute and relative performance of EM equities.
- Over the past few years, many headwinds have led to EM equities’ underperformance relative to DM, but we believe we are now at a turning point.
- We highlight the key tailwinds for the asset class below. Despite this positive outlook, EM equities currently trade at a historically wide discount to DM.
A weaker USD: there is an established negative relationship between the performance of the USD and EM equities. Following the U.S. election, we have seen the USD strengthen but we believe this is likely to be short lived. Several factors support a weaker currency going forward. In particular, we would highlight lower U.S. economic growth and rates, and the country’s large twin deficits. The valuation case is also compelling, with the USD looking overvalued relative to its own history, other currencies, and the U.S. economy’s fundamentals. Meanwhile, EM currencies have proved resilient in recent years, and we believe this improved performance can continue, given strong fiscal and trade account balances across many EMs.
China’s performance is improving: secondly, China, which represents a sizeable weight in EM equity benchmarks, has started to recover following several years of weakness. Despite the recent rally in Chinese equities, investor positioning and equity valuations remain at extreme lows. Meanwhile, history suggests there may be more market upside ahead. The three major stimulus-led rallies since the launch of the Chinese onshore CSI 300 Index in 2005 resulted in trough-to-peak gains of over 50-100%1.
Favourable growth outlook for EM countries: EM economic growth is becoming much more widespread and less dependent on China. Over the long term, there is a strong correlation between the relative GDP growth and relative equity market performance of EM and DM. Following a period of narrowing, the EM-DM growth differential has begun to widen and is expected to expand further in 2025, supported by robust economic growth across many EM countries and weaker growth in the U.S.. In coming years, EM countries are expected to account for 70% of global GDP growth2.
Improving earnings growth from EM corporates: there are also positive developments with regards to earnings growth, another important determinant of the relative performance of EM and DM equities. For the last few years, earnings per share (“EPS”) growth has been lower in EM than DM, on aggregate. However, this is now changing. EM equities are forecast to deliver higher EPS growth than DM in both 2024 and 2025, which should prove supportive for share price performance.
EM country fundamentals are in good shape: EM fundamentals have improved considerably in recent years, driven by economic reforms and prudent monetary and fiscal policies across many countries. A result of this is superior current account and fiscal positions relative to history and the developed world. Notably, the U.S. current account deficit is near its worst relative to EM over the last two decades, while the U.S. fiscal position is also weaker compared to EM. As a result, there has been a structural shift down in EM policy rates and, for the first time in history, full convergence with DM rates. This positions EM well in an era of monetary easing, given high real rates and contained inflation.
The asset class is becoming more attractive: the EM equities universe is becoming more attractive, with increasingly diverse country exposure and less cyclical stocks. We are seeing growing exposure to areas of structural growth, including consumer, technology, and green infrastructure, with a much broader choice of high-quality franchises than has historically been the case. Despite this, the asset class is trading amongst its highest ever valuation discount to DM equities.
1 Gavekal Dragonomics, Bloomberg, September 2024.
2 RBC GAM, IMF World Economic Outlook, Macrobond, October 2024. Based on IMF forecasts from 2024-2029.
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