Emerging markets remain vulnerable given the global backdrop, yet pockets of opportunity exist, particularly in hard currency debt and select emerging market equities.
The optimism surrounding emerging market (EM) assets diminished as 2023 progressed. Part of the initial enthusiasm was built on expectations of a reenergized China economy as it emerged from its zero-COVID policy, a weaker US dollar, and lower expected terminal rates. When this scenario did not materialize as envisioned, returns stumbled. As US yields hit new multi-year highs, the dollar restrengthened and China’s recovery disappointed, investors’ appetite for emerging market assets diminished, with equity and bond performance both impacted, albeit to varying degrees.
The tendency to view emerging markets as a singular bloc is misguided given the numerous idiosyncrasies among the countries that populate the EM universe. While there are undoubtedly shared risks across the emerging markets spectrum, such as the countries’ sensitivity to continued heightened geopolitical risks along with broad risk-taking appetite, it is important for investors to recognize where the variations lie. Key differences among countries include whether an emerging market country is an energy exporter or an energy importer, and whether the country is a manufacturing-based economy or a services-based economy. These important distinctions between nations highlight the heterogeneity of the grouping. Moreover, within the different indexes — namely MSCI Emerging Markets Index for equities and emerging market debt indexes for both hard and local currency — there are divergent performance drivers, making it difficult to have one conversation to represent them all. For example, Chinese equities account for about 30% of the benchmark emerging market equity index, while weighing 4.7% of the EM hard currency debt index and 10% of the local currency market. The arguments for investing in Chinese equities or bonds can be quite different.
From an investment case perspective, we are generally cautious about emerging markets. While we do not see much value in EM equities in aggregate, there are still opportunities. A higher-for-longer interest rate environment has been priced into emerging market equities. As a result, we have witnessed emerging market risk assets underperform, EM currencies sell off, and earnings expectations come down. Overall, we have a relatively more favorable outlook on emerging market bonds, with an emphasis on hard currency debt. We are now in a familiar place where a data-driven Fed has become again the dominant driver of emerging market debt returns. Hard currency sovereign debt looks attractive as EM spreads still offer value and, in the absence of a US recession, have the potential to tighten further.
Despite China’s continued challenges, we believe a relative opportunity exists. Active managers can focus their efforts on structural growth areas of the economy that have a government policy tailwind — such as technology independence, electrification, and other “new economy” areas. We also believe separating China from the rest of an emerging markets allocation warrants consideration, given the country’s high weighting of roughly 30% in the benchmark emerging markets index, low correlations, and global importance. Beyond its sizable concentration, slippage in China’s performance often leads to headwinds for other emerging markets, multiplying China’s impact on EM index performance. For example, weakness in the technology cycle impacted EM manufacturing, while softer demand for international goods led to lower orders for emerging markets countries to fill. However, the opposite is also true when the Chinese economy is performing strongly. A stand-alone China exposure allows investors the ability to dial their overall China allocation up or down as necessary. Figure 1 illustrates the diverging performance of China from the EM ex-China universe. Such an approach also adds flexibility around the type of exposures an investor may choose, whether it is the index/active split, investment styles, thematic, or small-cap tilts.
Outside of China, emerging markets tend to be heavy on cyclical companies and industries, making them especially sensitive to global economic activity. We expect sub-trend growth for the global economy in 2024, creating a headwind for emerging markets' prospects. Outside of China, allocators also need to be aware that concentration risks remain within the emerging market universe. India, South Korea, and Taiwan make up over 60% of the EM ex-China index. Furthermore, both Taiwan and South Korea have a single security that accounts for more than 30% of the countries’ respective index weight.
India’s ascent presents an interesting opportunity. With a young and growing population along with healthy economic growth (see Figure 2), the country has appealing investment characteristics. Its sector composition is well diversified and not reliant on any one particular industry; between them, financials, technology and energy sectors make up about half of the benchmark India equity index.
To understand the outlook for emerging market debt, it is important to distinguish between local and hard currency and to understand the key performance drivers of each. Local currency debt performance is driven by emerging market rates and currencies, while hard currency debt returns are driven by US Treasury and emerging market spreads. The resilience of the US economy has seen markets adjust their expectations, with the resulting sell-off in US Treasuries and strengthening in the US dollar having a negative impact on both hard currency and local currency debt performance and reversing gains achieved earlier in the year.
Given an evolving backdrop of heightened volatility and uncertainty, hard currency sovereign debt looks relatively more attractive because emerging market spreads, particularly high yield spreads, still offer value and, in the absence of a US recession, could tighten further (see Figure 3). The geopolitical landscape has become more unstable, but if the Israel-Hamas war does not develop into a broader regional conflict, the spread widening that it brought about, which remains limited, could represent a good entry opportunity into the asset class. A concern about hard currency debt is that it can be expensive in a climate where the US dollar is strengthening. If the US dollar weakens, then a more supportive environment would be found for hard currency debt. Moreover, while US Treasury volatility presents a short-term risk to the asset class, a potential rally in Treasuries once the US economy does turn presents added upside potential for hard currency debt.
After outperforming through the first half of 2023, the outlook for local currency debt has become more complex. It is noteworthy, and unusual, that emerging market monetary policy has decoupled from the Fed in recent years. emerging market central banks had responded quicker to inflation than developed peers in raising rates, and since emerging market inflation peaked late in 2022, the banks have been primed to start cutting rates earlier than their developed counterparts (see Figure 4). However, the outlook for emerging market inflation is clouded by a spike in oil prices and a stronger US dollar, which could drive inflation by way of the foreign exchange channel. Therefore, in addition to the negative impact that a strong US dollar has on emerging market currencies, a key question to consider for local currency debt is: How long can emerging market central banks diverge from the Fed?
An important recent development in the local currency space was the decision to include India in the flagship JPM GBI-EM Global Diversified Index from the second half of 2024, which will enable it to reach the index weighting cap of 10% once it is fully phased in. India’s inclusion brings much-needed diversification to the local currency index, while also allowing investors to participate in the growth potential of this large, investment-grade-rated country.
Even though emerging markets are affected by broader market volatility, we believe that there are still opportunities across this broad investment universe, notably in emerging market debt. Within equities, an active approach that focuses on structurally growing parts of the market is preferred. Overall, both emerging market debt and equities offer exposure to countries with superior economic growth and lower leverage compared to developed market economies, delivering diversification benefits as part of broader portfolios.