South Africa to cash in on emerging market boom 

Emerging markets are set to rebound over the coming months as interest rates come down, investors look to take on more risk, and developing economies continue to grow strongly. 

As one of the largest developing economies in the world with a highly sophisticated financial system, South African assets are likely to benefit from shifting investment trends. 

Despite the US stock market continuing to dominate global investing and drive returns for most investors, Ninety One’s Varun Laijawalla and Archie Hart argue the investing climate is shifting back in favour of emerging markets. 

In recent years, the emerging market equities seemed to reach a turning point on more than one occasion, only for hopes to be dashed.

They believe the risk is priced in, and a downbeat sentiment towards the EM asset class leaves it well-placed to make further progress.

Foreign equity investment in emerging markets today is low relative to historical levels, driven mainly by the poor performance of the Chinese stock market. 

India’s booming equity market has not been able to offset the size of the decline in its Asian neighbour, while many other emerging markets suffered from a strong dollar and rising interest rates. 

Typically, when interest rates rise, particularly in developed economies, investors’ risk appetite declines as there is a relatively high rate of return on ‘risk-free’ assets such as government bonds. 

When interest rates fall, investors in developed markets must begin looking for yield elsewhere and taking on more risk in exchange for higher returns. 

Laijawalla and Hart outlined five factors that indicate a more favourable outlook for emerging market equity returns.

1. A powerful headwind is set to wane

There is a strong inverse relationship between the US dollar and the performance of emerging market equities.

A strong dollar is generally a headwind for these markets as it makes servicing US dollar-denominated debt more expensive and can lead to a reversal of capital flows. 

The situation today closely resembles the period highlighted on the left-hand side of Figure 1 shown below, where the US dollar peaked in the early 2000s, preceding a stellar run for EM equity returns. 

“However, we don’t need the US dollar to fall for the EM equity asset class to succeed, we just need it to stop rising as steadily as it has over the past ten years,” Laijawalla said.  

With Fed rate cuts on the horizon, we may see an easing in the one-way dollar trade. This is important for EM equities, which tend to outperform in a dollar downcycle over a multi-year period.

2. Stronger fundamentals

Substantial progress has been made by emerging developing countries on the macroeconomic front, making them more resilient to external shocks. 

At the macro level, it is widely recognised that many emerging market central banks have skillfully navigated the recent hiking cycle, proactively tackling inflation ahead of their developed market counterparts. 

Thanks to benign inflation dynamics, the prospect of further rate cuts for emerging markets provides a cyclical tailwind for equities in these markets. 

The reduction in the cost of capital should also help stimulate economic and business activity in EM economies.

At the corporate level, there has also been a push for higher standards of operating performance and corporate governance. 

“The increased levels of share buybacks and dividends paid out paints a positive picture and signals that management teams believe their shares are undervalued by the market,” Hart said.  

3. Structural tailwinds

Supportive tailwinds for emerging market equities include rising income levels in emerging markets and the associated increased demand for products and services. 

Global economic momentum is shifting away from advanced economies towards emerging markets, as they are forecast to deliver higher GDP per capita growth. 

Furthermore, the shift to a new multipolar world economy means some emerging markets, like Mexico, Vietnam, and India, are already starting to benefit, returning an average of 20% since 2021.  

Other multi-decade structural themes include technological development, the drive towards net zero, efforts to enhance supply-chain resilience, government stimulus and infrastructure expansion. 

4. Robust earnings growth

Emerging markets are expected to deliver higher earnings growth than most other major regions over the short- to medium-term. 

These markets are expected to generate around 20%+ earnings growth forecast in the next year and high teens in the following year. 

That’s higher than what’s on offer in developed equity markets, with returns of 10.9% and 14.6% for MSCI USA and 5.5% and 9.9% for MSCI Europe, respectively.  

5. Compelling valuations

EM equity valuations have been attractive for some time now, with metrics like price-to-earnings ratios among those that have not changed much in 10 years. 

Part of this is driven by Chinese companies, including those that are high quality, that are now trading on depressed multiples. 

Valuation alone is not a signal, but it sets the right starting point for other conditions to drive a re-rating, especially as the gap between emerging markets and the US is now near its widest in 40 years.