Globe WorldWatch

Time for EM assets to shine

WorldWatch

Amid a widening economic growth differential, attractive relative valuations and light investor positioning, we see multiple reasons for asset allocators to revisit EM, with the Fed’s first rate cut being a key catalyst for this shift to begin in earnest. After many years of disappointing returns from EM assets, we believe it is their time to shine. 

Just over a year after raising the Fed Funds rate to 5.25%-5.5%, the world’s leading central bank has made its long-awaited decision to ease US monetary policy.  This is a momentous event, and will likely precipitate a series of rate cuts, with 3-month rolling underlying inflation already below the Fed’s 2% target. 

US Core PCE Inflation

US Core PCE Inflation

Source: Bloomberg

While the US labour market has been resilient so far, other areas of the economy are clearly showing weakness, suggesting that the Fed may need implement a series of relatively aggressive cuts to avert a deeper slowdown. Thus, as the chart below shows, rate differentials with other major world economies look set to narrow sharply, particularly versus Japan, which is likely to continue its modest tightening cycle. This is one pillar of support for the US Dollar that appears to be rapidly crumbling.

Market Rate Expectations

Market Rate Expectations

Source: Bloomberg

Unusually, in this cycle inflation has been a far greater problem for developed economies than emerging ones. Consequently, while rates are now falling across much of the world, they should drop far quicker in the US than in EM. This would be positive for EM assets and flows, and negative for the Dollar. Local EM debt is likely to perform well in this scenario, and with some central banks (such as Brazil’s) bucking the easing trend, the case for active management in EM remains extremely strong.

Since the turn of the century there have been four rate cutting cycles, including this nascent one, with the previous three averaging 425bps of cuts.

Fed Funds Rate – Upper Bound

Fed Funds Rate – Upper Bound

Source: Bloomberg

Whilst it remains unclear where rates will trough in the coming cycle, we do believe that there is scope for significant cuts that will ultimately change the narrative for EM assets in the months and years ahead. 

In addition to the narrowing interest rate differential eroding support for the Dollar, GDP growth expectations are no longer looking favourable from a US perspective. As shown below, consensus expectations are for the economic growth differential between EM and the US to widen to a 7-year high in 2025.

US vs EM GDP Growth

US vs EM GDP Growth

Source: Bloomberg

According to the Financial Times and IMF, the proportion of EM economies whose per capita GDP is expected to grow faster than those in the developed world is due to rise from 48% over the past five years to 88% over the next five. This is expected to occur even against a backdrop where the largest Emerging Market is struggling, showing that many developing economies have substantially reduced their dependency on China. Clearly there is further upside to this scenario if Chinese policymakers materially increase support for their flagging economy. Recent actions to stabilise asset prices signal the government’s intent to draw a line in the sand, increasing the likelihood of more support for the real economy in due course. With the US fiscal deficit approaching 7% of GDP this year, and a high likelihood that it will widen further in 2025 under either presidential candidate, the Dollar will likely come under further pressure. Unusually, both current account and fiscal budgetary positions are significantly worse across most developed economies than developing ones, suggesting to investors that the concept of a ‘risk premium’ in EM should be re-considered.

US Debt Dynamics are Unfavourable

US vs EM GDP Growth

Source: Economist

As an aside, there is a similar argument to be made about the geopolitical risk premium in EM, which is often a key concern for asset allocators. Geopolitical issues are not a unique EM phenomenon. There are significant geopolitical risks in the US ahead of the elections, and in Europe, where election results are becoming increasing polarised. Moreover, when assessing geopolitical risk, it is important to recognise that EM is not a homogenous block, and also to look at the sequence rather than an isolated event. To take one example, Sino-US trade tensions were seen as a major negative for EM assets. However, this view is overly simplistic and short-sighted. Indeed, the tariffs have led to major changes in global trading patterns, presenting countries such as Vietnam and Mexico with huge export opportunities. As the US and China continue to decouple and world becomes more fragmented, active EM managers should be able to capitalise on the opportunities that this throws up.

Re-focusing on the US Dollar, using long-term valuation comparisons such as Purchasing Power Parity or Real Effective Exchange Rate, the Dollar would appear to be substantially overvalued relative to a basket of EM currencies. For example, the Economist’s “Big Mac Index” shows the Chinese Yuan to be 36% undervalued against the Dollar, whilst the Indonesian Rupiah and South African Rand are 54% and 46% undervalued, respectively.

Big Mac Index – Undervaluation vs US Dollar

Big Mac Index

Source: Bloomberg

These data points are revealing because the trajectory of the dollar is critical for EM assets. Since the turn of the century, there has been an 87% positive correlation between a weaker Dollar and EM equity outperformance versus DM. EM debt has a similarly strong correlation. With the era of Dollar weakness having seemingly begun, EM assets should enjoy a strong tailwind.

EM Equities Well Correlated with Dollar Weakness

EM Equities Well Correlated with Dollar Weakness

Source: Bloomberg

Despite this improving picture, foreign ownership of both EM equities and debt would appear to be exceptionally low.  After many years of persistent outflows from both EM bonds and equities, this trend looks set to reverse, exacerbated by outperformance of these asset classes and the likely strengthening of a basket of EM currencies relative to the US Dollar.

EM Equity and EM Fixed Income Flows

EM Equity and EM Fixed Income Flows

Source: eVestment

In addition to the catalysts of a weaker Dollar and stronger growth in developing economies, EM valuations appear to be extremely compelling – again for both debt and equity asset classes. As can be seen below, sovereign credit still offers very attractive yields relative to history. 

EM USD Sovereign Yields (%)

EM USD Sovereign Yields (%)

Source: Bloomberg, Morgan Stanley Research.

In the high yield space, EM has already endured a default cycle over the past two years and is now in a recovery phase. By contrast, the US is likely to see a spike in defaults as the economy slows. Given their respective stages in the cycle, there is a strong argument to say that EM high yield should trade at a spread discount to US high yield.

EM versus US and EU high yield

EM versus US and EU high yield

Source: BoA Global Research

The argument that yield differentials should tighten substantially from here is compounded further by the fact that EM corporate leverage is far lower than in DM.

Leverage by Rating Bucket

Leverage by Rating Bucket

Source: Bank of America

Meanwhile, EM equities trade on a 36% discount to DM (on forward earnings estimates), and a huge 45% discount to the S&P – both far greater than their 10-year medians of 27% and 33%, respectively.

EM P/E Valuation Discounts at Decade Highs

EM P/E Valuation Discounts at Decade Highs

Source: Bloomberg, IBES est PE

This is despite the fact that EM fundamentals are clearly improving, with earnings revisions expected to be strongly positive, substantially outpacing those in DM.

12mth Forward EPS Growth Expectations

12mth Forward EPS Growth Expectations

Source: Bloomberg, IBES.

Such positive earnings revisions are perhaps unsurprising as developing economies have multiple drivers of strong economic growth ahead, including substantial exposure to commodities such as copper and lithium that are critical to both AI and clean energy technologies. Chile and Indonesia are two notable commodity producing winners, while much of the supply chain for AI datacentres sits within Korea and Taiwan. Other economies such as Vietnam and India are substantial beneficiaries of a world where multinationals are looking to diversify their manufacturing bases away from China. On top of these export opportunities, many developing economies still have favourable demographics and under-penetrated domestic markets, providing long runways for structural growth. 

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