After 15 years in the desert, have emerging market shares finally reached the oasis?
Tom Stevenson
5 min read
Half of China’s household wealth is tied up in the country’s beleaguered property market - JESSICA LEE/EPA-EFE/Shutterstock
Transport yourself back 15 years and imagine you are thinking where to invest your savings in the immediate aftermath of the worst financial crisis since the Great Depression.
The financial world you contemplate has been brought to its knees by a US-led credit and housing bubble and is being put back on its feet in large part by an unprecedented £300bn Chinese-led stimulus plan. You might reasonably conclude that you are witnessing a historic changing of the guard, a transfer of economic power from America to a new set of powerful emerging markets bending the knee to Beijing.
As the basis of an investment strategy, this would have been a mistake. Had you invested £100 in an index of emerging market shares in September 2009, you would have £121 today. The same amount focused on China itself would be worth just £95.
Had you instead put your faith in a global stock market recovery over the next decade and a half you would have grown your £100 to £324. And if you had simply bet that America would bounce back to regain its economic leadership, your £100 investment would today be worth £539.
Emerging market shares have undergone a massive de-rating since 2008. They trade at around a 35pc discount to their developed market peers and their weight in the average global mutual fund has fallen from 13pc in 2010 to 5pc today. Since the pandemic, things have gone from bad to worse.
Emerging market shares have been hit by a strong dollar as US interest rates rose and stayed higher for longer; they have suffered from the dire performance of the Chinese economy and stock market since 2021; in the last three years they have been weighed down by a generalised risk-off sentiment among investors and a rise in geo-political tensions.
In that context, last week’s pivot towards easier monetary policy by the Federal Reserve may prove to be a catalyst for change. This week’s impressive, but maybe insufficient, stimulus package in China shows how policymakers were waiting for the US to open the door to action in the rest of the world.
The ingredients are in place for the pendulum to start swinging back towards riskier investments like emerging markets. What was missing until last week was the trigger.
Higher for longer interest rates in America were a nightmare for many emerging markets. Countries like Brazil, Poland and Mexico had burnished their credibility by raising interest rates well ahead of the Fed to bring inflation under control.
Last year, shares did well in anticipation that lower borrowing costs would support consumers and businesses and drive investment flows into emerging stock markets. But the Fed remaining on hold for three quarters of 2024 put those plans on ice as central banks feared for their currencies.
That all changed last week. And with markets now pricing in another 1.5 percentage points of US rate cuts by the end of next year, emerging markets can follow suit. A soft landing is the base case. Weak oil reduces inflationary pressures. Investors can focus on emerging markets’ better current account balances, their foreign exchange reserves and lower borrowing costs.
After 15 years crawling through the desert, have investors reached the oasis?
That will depend on two other key ingredients for an emerging market recovery – China and commodities. China continues to account for a sizeable proportion of the emerging market index, even after its recent weakness. And it has been a dead weight around the investment class for years.
The reasons are well known and largely focused on a prolonged slump in the country’s property market. With up to half of household wealth tied up in property, the implosion of the housing market has had an enormous impact on consumer confidence.
The government’s piecemeal approach to stimulus has done little to help. The latest measures will improve liquidity but what the country needs is a changed mindset – having the money to spend is one thing; wanting to do so is something else.
Add in terrible demographics – 9m births a year but 12 million entering the over-60s age-group – and fears of a damaging second phase of the US-China tariff war, and it is unsurprising that investors have shunned Chinese shares. Their average valuation stands at around nine times expected earnings, less than half the multiple applied to both US and Indian shares. Popular stocks like China Mengniu Dairy have seen their ratings tumble from 50 times earnings three years ago to 15.
The final, and related, ingredient for an emerging market recovery is what happens next in commodities. The performance of the emerging market index is closely correlated to the price of key commodities like iron ore and copper.
Here, there is a gap between the long-term outlook – compelling for metals like copper thanks to its importance to decarbonisation, electric vehicles, infrastructure and data centres – and the short-term picture, driven as it is by China’s dim prospects and a slowdown in the US and Europe. The scale of the headwinds in commodities is illustrated by the oil price – down from $130 (£97) a barrel only a couple of years ago to $70 today.
So, the backdrop for emerging markets is improving. But the timing of any recovery is unclear. Emerging market shares are cheap, interest rates are moving in the right direction, sentiment towards China is potentially stabilising and the long-term picture for commodities is positive. Whether investors will be prepared to take the plunge before the US presidential election in November is a different matter.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
