I love Emerging Markets.
It’s where I have spent most of my investing career and where it really feels like the world is slowly moving in the right direction – with the tiniest bit of help from me. The investment case has always been simple: poor people with bad leaders open up to the discipline of markets that require good policies and honest government. At first, it’s the low-cost labor that draws capital; ultimately, it’s the prospect of a billion new members of the global middle class.
That’s the idea. Of course, the reality is messier.
Billions have, indeed, emerged from poverty, even if there remains plenty of corruption and mismanagement. Stunning progress in Poland and Chile must be weighed against recurring crises of Argentina and Turkey. In some years, the profits have been stellar, but the average annual equity return is 2.8% over the last decade, about a third of the MSCI All-Country World Index.
Rangebound
With a fresh rate-cutting cycle coming into view, however, it’s time to test the investment case once again. The very fact that most Emerging Markets weathered the pandemic collapse in global trade and subsequent rate hikes without a major disaster speaks volumes. These are mainly countries with strong balance sheets, flexible exchange rates and sound banks.
In advance of the G-20 finance ministers and central bankers gathering in Rio de Janeiro today, the International Monetary Fund has updated its forecasts with a still depressing picture of sluggish growth and lingering inflation. Global growth is expected to be 3.2% this year and 3.3% in 2025, far short of the 3.8% average this century until the pandemic struck.
Nevertheless, the new forecasts have "developing and emerging economies" set to grow at 4.3% this year and next, including improving expectations for India and China. Brazil and Mexico look sluggish this year but should do better in 2025. Meanwhile, global trade growth is expected to recover to 3.25% after stagnation last year. And a separate IMF study shows that, excluding China which continues to suffer from murky policies, capital inflows to Emerging Markets have recovered from a post-pandemic low.
Is the tide about to turn?
Two warnings here. First, growth and inflation trends are only vaguely related to financial market returns. Second, the term "Emerging Markets" covers a dog's breakfast of large (India) and small (Chile), commodity exporters (Brazil) and importers (China), more developed (South Korea) and less developed (South Africa).
But all else equal, falling rates and better trade should mean a weaker U.S. dollar, cheaper debt and expanding investment flows. The MSCI Emerging Markets Index has delivered roughly 7% return so far this year, half of the S&P 500, so there’s plenty of ground to make up. Equity valuations look especially cheap compared to developed markets overall and the U.S. in particular.
But it still feels early to expect that the next whoosh you hear is the sound of money rushing into Taiwan and Saudi Arabia.
Emerging Market investors, who must often distinguish among countries that "won't pay" their debts and countries that "can't pay" their debts must also separate the pots of global money that “can invest” in these riskier countries and those that “must invest.” As long as the safest asset in the world pays more than 5% interest, there's very little incentive for any portfolio manager to feel compelled to take a much bigger risk for an elusive return.
That risk-free return will fall as the Fed cuts begin, but the money that’s ready to take a little more risk will start in U.S. (or European or Japanese) stocks. Only when developed markets look unable to deliver the target returns of a pension or insurance investor will my favorite Emerging Markets get the attention they deserve. As a guess, that won’t happen before Treasury returns to drop closer to 3.5-4%.
Despite rising authoritarianism in China and rampant corruption in South Africa, the political and economic outlook for most emerging markets is far superior to what it was 30 years ago when the asset class first appeared. If the secular investment case remains solid, financial returns all depend on good timing.
Soon, but not yet.