The shift in global supply chains away from China adds to the opportunity set for the more dynamic emerging markets to increase their share of US imports, benefiting from the trend of ‘nearshoring’. Emerging markets have always shown resilience and adaptability, with many successfully managing their way through recent macro headwinds and their positive growth outlook appears set to continue their good start in the first half of 2024.
We believe there are in fact five good reasons emerging markets are close to an inflection point.
1. We are at the start of a big technology upcycle, clearly driven by artificial intelligence (AI) expanding into data centres, new architectural designs and so on. There are many companies key to the supply chain in emerging markets, in memory as well as other critical components such as the foundries manufacturing the chips. We think technology companies will drive a strong earnings cycle over the next 12-24 months, much of this from South Korea and Taiwan but, given their size, significance and the cyclicality, when these earnings turn around we believe they will give an uplift to the whole earnings per share growth story.
2. The second driver is growth and consumption in many of the core emerging economies – the likes of India, Vietnam, Indonesia and Brazil. There has been pent-up demand as well as tight monetary and fiscal policy across emerging markets for a good period already. In July last year Chile was the first emerging market to begin what we believe could be a significant loosening cycle. Latin American economies had raised rates earlier and more aggressively than the rest of the world, in 2021-22, but now double-digit nominal rates are rendering real rates too high for the overall outlook. As inflation tumbles we are set to go into reverse.
3. The third factor also relates to the Federal Reserve (Fed) cutting interest rates, a positive for emerging markets. The implied risk premium in emerging markets is high, driven largely by the negative perception of China, tight monetary policy and inflation nervousness. With the Fed cutting rates, we will likely see more of an easing cycle leading to better liquidity in the local market alongside a new investment and consumption cycle. This will hopefully lead to a reduced risk premium across emerging markets. When the Fed starts to cut interest rates, there will be an inflection point for many of these economies to start their own aggressive rate-cutting cycle. The specific timing is difficult to predict but our best forecast is the end of 2024, after the US election.
4. The downside risk to China's weakness is that some of the GDP growth forecasts look overly optimistic. However, we still think that from an equity market and earnings perspective, we are close to the bottom. After three years of underperformance, China is no longer deteriorating which we believe is enough to help lift the overall earnings growth forecast and it will still play a significant role as the exporter of consumer and capital goods into the new emerging market growth areas.
5. The final driver is South Korea’s ‘Corporate Value up’ program, akin to its government trying to copy similar programs in Japan, though there are clear variations and differences. South Korea is trading at a huge discount, with many issues related to what we see as poor public governance structures, weak capital allocation and capital market structures. The government has outlined policies that would make the capital market work much better, which should help lift the discount. Given the size of the South Korean market and the extremely low valuations, it has the potential to lift a great deal. Our best estimate is this could continue for the next 3-4 years – it will not happen overnight but it is positive and moving in the right direction.
