The current stock market’s blink-and-you-missed-it correction is a clear indication that shares remain on an upward trajectory. These rapid-fire round trips happen when investors are busy looking for reasons to buy not sell, to see the glass as half full. The S&P 500 lost 5.4pc in three weeks between the end of March and the middle of April. But within a month it had recovered all of that and more.
Another indication that the bulls are in charge for now is the breadth of the recovery. Investors sense that lower interest rates are on their way and have started to look beyond the market leaders. The equal-weighted version of the US benchmark has finally moved beyond its 2021 peak, with 80pc of companies trading above their 200-day moving average, a key measure of momentum. Smaller companies, too, have broken upwards out of their three-year sideways drift.
Crucially, the prospect of the US Federal Reserve (Fed) joining its counterparts across the Atlantic in a co-ordinated easing of monetary policy has seen the dollar give up its recent strength. It had gained around 5pc by the middle of April against a basket of other currencies, and it is now on track for its first down month of 2024. That has lit a fire under risk assets like commodities and emerging market equities, the investments that have borne the brunt of the US central bank’s restrictive approach.
Commodities are priced in dollars, so a weakening of the US currency makes them cheaper to buyers elsewhere in the world and boosts their price, all other things being equal. The copper price was US$8,000 a tonne in February; it is US$11,000 today. Gold has risen by 20pc over the same period and silver by even more.
Stock markets in the developing world also like a weak dollar, because, among other things, it reduces the burden of any borrowings that are denominated in the US currency. Emerging market shares have risen by more than a fifth in the past six months, despite the main contributor to that performance, China, rising by only 5pc since October.
Stripping China out of the MSCI Emerging Market index paints a more encouraging picture. On this basis, shares in the rest of the developing world have recouped all the losses incurred since the 2021 post-pandemic peak. It is early days, however. Over the past 10 years, emerging market shares have gone sideways while the US stock market has nearly trebled. What are the chances of the next decade seeing a reversal of that trend?
There are many strands to the case for emerging markets - some short term, others a slower burn. Crucially both sets are now pointing in the same direction.
The tactical reasons to favour emerging markets today include the growing likelihood of a soft landing for the global economy. The return of inflation towards many central banks’ 2pc target makes interest rate policy look too restrictive. The cost of borrowing will fall from here. At the same time, economic growth and corporate earnings are strong enough. Not too hot and not too cold is the Goldilocks scenario. Crucially, though, GDP growth in emerging markets, at nearly 5pc, is more than three times that of the developed world.
The economic fundamentals in emerging markets are also much better than they were 10 years ago. Current account balances have improved, there is less dollar-denominated debt and greater foreign exchange reserves. Developing countries are much better insulated against future shocks. Having moved quickly to raise interest rates, they also got on top of inflation ahead of the developed world and in some cases are already cutting the cost of borrowing.
Other short-term advantages include the exposure of many emerging markets to the nascent commodities boom. The ongoing shift towards a net zero world has highlighted the gap between growing demand and inadequate supply for many natural resources, including metals like copper and nickel that are key components in the build-out of clean energy and electric vehicle infrastructure. Another under-appreciated advantage is the developing world’s exposure to artificial intelligence (AI) via its dominance in semiconductor production.
All of these tactical advantages build on the long-term structural case for emerging markets. This includes their demographic edge, with 90pc of the world’s working age population and two-thirds of its high-consuming middle class expected to be living in emerging markets within a few years. The developing world accounts for 80pc of economic growth, nearly 60pc of GDP but only 11pc of the value of global stock markets.
Part of this is due to the lower valuations attached to emerging market shares. They trade on a multiple of earnings in the low teens compared to nearly 20 for developed markets and even more in the US. This despite expected profits growth being significantly higher - 19pc versus 11pc this year, according to Lazard. You would expect riskier emerging markets to trade at a discount to their safer developed market peers, but the gap is wider than it should be.
There are different ways of playing emerging markets, an extremely diverse investment set. My preference is to put my eggs in several baskets. India is on a roll, with booming services exports (up 150pc since 2019) accompanied by a growing manufacturing sector as companies like Apple look to diversify their supply chains. But it is expensive, trading on a par with the US market, with high valuations most obvious in hot areas like consumer stocks.
China, on the other hand, is out of favour, with a long list of headwinds, from a potential Trump Presidency to a fragile property market which still accounts for a worrying proportion of Chinese savings. The price you are being asked to pay, as an investor, is commensurately low, however. Valuations remain extremely depressed despite a nearly 20pc rebound since February.
There is a strong case for maintaining a permanent exposure to emerging markets to share in their long-term growth advantage. Today, I’d argue that the stars are aligned for short-term tactical outperformance too.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
