The outlook for emerging markets (EM) is looking positive as the US Federal Reserve signals a shift towards more accommodative monetary policy, amid other tailwinds.
Particularly, the economic fundamentals are much better than in prior years, according to investment executives, and EMs are demonstrating resilience and growth potential despite indications of central bank hawkishness.
Earlier this month, Oxford Economics’ latest hawkishness index for July, measuring the relatively aggressiveness of central banks, found EM hawkishness remains high, suggesting many economies will likely undershoot their inflation targets.
“Prolonged monetary policy hawkishness presents a significant risk to demand growth across EM,” it said.
“In the short run, central banks can justify tight policies as progress on disinflation has slowed and because of heightened financial market volatility. But our real activity tracker reveals that activity lost momentum in the EMs with the highest hawkishness index.”
It has maintained its aggregate 2024 EM GDP growth forecast at 4 per cent but nudged down its 2025 projection to 3.9 per cent. It has also increased its policy rate forecasts for most EMs in 2024 and 2025.
Offering specific country insights, it highlighted central banks in Mexico and the Philippines, among others, have cut rates due to signs of slowing growth. Meanwhile Brazil and Malaysia are expected to keep rates on hold, noting a risk of cuts if inflation expectations don’t fall.
Despite this mixed bag of outcomes, EM investors maintain optimism over the trajectory of these markets in coming months.
According to Joseph Lai, chief investment officer at Ox Capital, EM central banks’ monetary policy has been “sensible” in balancing inflation with economic growth.
“Central banks in Asia and emerging markets have maintained high interest rates to match the relatively high interest rates in the US. Despite the higher rates, most of these economies do not have meaningful inflationary pressures and are growing robustly,” he told InvestorDaily.
With US Federal Reserve chair Jerome Powell indicating last week that “the time has come” for monetary policy easing, all but confirming interest rate cuts are on the horizon in September, the prospects are bright for EM equities, Lai elaborated.
“The upcoming US rate cuts and a weaker US dollar are highly positive for emerging markets and EM equities have historically performed well during US rate cut cycles,” he said.
Economies like India, Indonesia, and Vietnam are thriving despite the slowdown in other markets like China and the US, Lai pointed out, and valuations in EMs are typically attractive, trading at multi-decade lows in price to earnings and price to book valuations.
This, he continued, is an important fact given EM equities have historically outperformed developed markets over the long-term.
“A general lack of interest has led to extraordinarily appealing valuations,” he said.
“We are looking at an attractive entry point with forward price to earnings multiples at depressed levels for quality companies with sustainable long-term growth and a backdrop supportive of outperformance.”
Additionally, this trend will only be benefited by high interest rates dropping rapidly in these economies.
“For example, Indonesian banks are experiencing robust growth, minimal credit issues, generating high returns on equity, trading at attractive price-to-book ratios, and offering dividend yields of as much as 6–7 per cent,” Lai said.
Samuel Bentley, client portfolio manager at Eastspring Investments, also suggested selected EM central banks are likely to lower their interest rates alongside the Fed cut, especially with the backdrop of stabilising domestic inflation and a slowing economy.
“This could provide a supportive environment for their domestic equity and domestic bond markets in local currency terms,” he told InvestorDaily.
Over the next 12 months, as a monetary easing cycle overlaps with the US election cycle, he foresees lower uncertainty, lower interest rates and a weaker US dollar being structurally supportive for EM equities.
EM equities could even perform in line with US equities, albeit with elevated volatility, in the second half of 2024, Bentley observed.
“We have seen a widening in aggregate GDP growth expectations for EM over developed markets for the next few years, which has typically correlated with equity market outperformance for EM equities,” he said.
Like Lai, he also highlighted the reasonably cheap valuations in EMs, which could prove advantageous. In particular, he pointed to Latin America, where the firm sees many valuation opportunities, particularly Brazil and Mexico, as well as South Korea and China where market pessimism continues to price in extreme outcomes.
“Historically low investor positioning in EM plus very supportive relative valuations means that, if there are no overt headwinds, cheap valuation itself could drive much stronger EM performance,” Bentley said.
“EM equities are trading at least one standard deviation cheap versus historical averages whereas the US is more than one standard expensive.”
