Global emerging markets (EMs) face challenges; however, fundamentals remain strong and valuations are better than in developed markets. That said, we need to harness active stock selection based on fundamental analysis to construct a portfolio of high-quality companies that can generate sustainable returns over the medium to long term.
What is the investment outlook for emerging market equities in 2024, given the prevailing macro environment (slowing global growth, geopolitical, higher rates)?
Global markets face multiple challenges. Higher US interest rates make investors wary of all risk assets, while China, the largest component of the EM asset class, is grappling with slow growth, increased regulatory scrutiny and geopolitical risks. This is resulting in record outflows as global money managers reduce active positions, particularly in the mainland China and Hong Kong SAR markets, leading to multiple derating that is disproportionately larger than the slowdown in earnings.
Yet, we believe that EMs are better placed today than in the past. Having learnt from previous crises, EM economies are on a firmer footing with robust government balance sheets, better current account balances, comfortable foreign exchange reserves and higher import cover. Interest rates have been held at higher levels even as inflation receded, leading to positive real rates in most EMs. Meanwhile, most emerging economies' underlying structural growth trends should keep driving corporate earnings over the medium to long term.
Considering this, EMs possess strong fundamentals, even though near-term concerns are leading to weak sentiments and sharp valuation derating, making EM equities trade at historically low valuations versus developed market equities. While it is hard to predict when a recovery will happen, and sentiment will improve, we believe EM equities offer a better risk-reward ratio for investors over the medium to long term.
What do you think could surprise markets in 2024, either positively or negatively?
The market could get a positive surprise from China. It is the world’s second-largest economy, with a large pool of skilled workers who drive innovation and global competitiveness. Consumption is bound to come back at some point. We are well-positioned for this with an overweight in high-quality consumer companies at attractive levels.
Also, China’s dominance in the global supply chains has been built over several decades and will take many years to be replicated elsewhere. Hence, completely blocking China is as much a risk for China as it is for the rest of the world. While investors have disproportionately penalised Chinese equities, their negative view of China is not equally reflected in their investments in other parts of the world. As investors realise this, we should see a recovery in China.
We recognise that the risk in China has increased by raising our risk premium on Chinese companies. While we do not want to go overboard, given where valuations are, we think this is not the time to sell out of China.
Within your portfolio, what has worked well in 2023?
In 2023, the portfolio benefitted from its overweight in technology hardware stocks that advanced on expectations that the semiconductor down-cycle was starting to bottom out. The hype around artificial intelligence (AI) and indications that it could drive demand for high-performance chips also supported the sector after US company Nvidia forecasted strong revenue growth and said it was boosting production of its AI chips to meet surging demand.
We have been counter-cyclical in our information technology (IT) sector positioning. We added to our holdings last year when stock prices were reasonable due to global growth concerns, and as these stocks did well this year, we have been booking some profits to invest in areas where returns are expected to be higher.
What themes, sectors or regions would offer opportunities and potential risks?
While shifting global supply chains is a slow process, our corporate interactions suggest that companies are redirecting production to other countries that are closer to home (the trend of nearshoring) or to friendly partner countries (friend shoring). This is expected to benefit several EM economies.
We have increased our exposure in Mexico; its proximity to the US is leading to a marked increase in the nearshoring of global supply chains. We also have a positive view on India, which is insourcing production capacities in areas like information technology hardware, chemicals and textiles. The country also benefits from structural growth in consumption and higher investments in infrastructure and manufacturing.
While Brazil has always been a tough market for us because the long-term structural growth is low (at around 1-2 per cent) and more volatile (with frequent recessionary periods), we found interesting investment opportunities early in 2023 when valuations were cheap, interest rates peaked, and inflation fell, leading to positive real rates.
