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by Christoffer Enemaerke, CFA, Portfolio Manager, RBC Emerging Markets Equity, RBC Global Asset Management (UK) Limited Dec 28, 2023

Central banks in many emerging-market countries were fast to react to rising inflation following the pandemic and started tightening monetary conditions in advance of developed-market central banks. We are now entering an unprecedented situation where policy rates in emerging markets are converging with developed-market rates and poised to drop below them for the first time. Inflation-adjusted interest rates are at historically high levels in emerging markets, making it easier for them to reduce nominal rates. Policy rates have already been cut in Brazil and Chile, and we would expect more emerging-market countries to follow suit over the coming months.

The early tightening cycles in many emerging markets brought down inflation, and policy rates and bond yields now appear to have peaked in many markets. As a result, emerging-market bonds denominated in local currencies significantly outperformed developed markets in recent years. In contrast to bonds, emerging-market equities extended their decade-long underperformance versus developed markets. Much of the relative weakness has been driven by China, which accounts for almost a third of the MSCI Emerging Markets Index.

One of China’s main issues following the pandemic has been consumers’ lack of confidence in the economy, leading to increased savings rates and anemic consumption. China already has one of the world’s lowest ratios of consumption to GDP, and unlocking consumer potential will be a key for long-term economic growth. Lower consumption is also explained by the fact that China has a less developed social safety net, which means Chinese families must keep more savings in reserve to pay for medical care, old age and education.

The Chinese government has started to introduce more stimulus measures in recent months, including rules loosening down-payment requirements for mortgages, in an attempt to boost the residential-property market. This step is important as property is one of the main drivers of consumption in China. We expect more consumption-boosting measures in the form of social-welfare spending.

The rise in geopolitical tensions between the U.S. and China, which has imposed non-tariff trade barriers such as quotas, has led China’s trade partners to diversify their supply chains. China’s share of U.S. imports peaked at 21% in 2018 and has since fallen to 14%. However, China has a highly skilled labour force, a complete industrial ecosystem, strong infrastructure and a large domestic consumer market. So while China’s share of U.S. imports has decreased, its share of value-added exports continues to rise, reflecting continued improvement in export competitiveness. One example of this evolution is China's environmental supply chain, which has helped offset the loss of market share in the electronics supply chain.

There have been four major cycles of emerging-market equity performance over the past three decades, with durations ranging from six to 12 years. Two of the cycles were characterized by strong relative performance versus developed markets and two cycles by weak performance. The most important long-term predictor of emerging-market returns versus developed markets has been earnings growth measured in U.S. dollars. The most recent of the cycles has now lasted 12 years, with zero annual earnings growth in emerging markets over this period, and has coincided with significant underperformance relative to developed-market equities.

We would expect the decline in emerging-market interest rates over the next year to occur faster than any declines in developed markets, and for the drop in emerging-market rates to bolster the earnings of emerging-market companies. The improved emerging-market earnings outlook in turn suggests better relative performance for stocks in emerging markets.

An important driver of GDP growth for emerging markets in the long run has been urbanization. Typically, we have seen per-capita GDP increase as the percentage of the population moving to cities has climbed. For example, China’s GDP per capita rose exponentially over the past 30 years along with surging urbanization. Some of the largest emerging-market countries outside of China, including India and Indonesia, still have strong potential for urbanization to drive long-term economic growth.

MSCI Emerging Markets Index Equilibrium

Normalized earnings and valuations

Source: RBC GAM

From a valuation perspective, emerging-market equities continue to look particularly cheap in comparison with developed-market equities. Emerging-market stocks trade at a 45% discount to developed markets based on price-to-book value – close to the lowest level in 20 years. Another indicator that suggests emerging markets are attractively valued is the Shiller CAPE Ratio, which is based on average inflation-adjusted earnings over a 10-year period. Emerging markets trade at a CAPE Ratio of 12.5x, half the 25x figure for developed markets. While valuation levels are generally unreliable as predictors of performance over short-term periods, the long-term relationship between returns to equities and valuations is robust. Against this backdrop, current valuations of emerging-market equities look relatively attractive.

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Disclosure

Date of publication: Dec 28, 2023

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