Views from the collective: Where next for emerging markets?

China’s stumbling economic growth has opened the door for India to take centre stage. And while global markets are still monitoring the health of the US economy, emerging markets are less tied to the US dollar than in the past.

Everywhere you look, emerging markets (EM) are changing. The term itself now covers a far wider array of constituents within the various EM indices than was originally envisaged in the late 1980s. It was intended to mobilise foreign portfolio investments to developing economies by spreading the risks across a range of markets and continents with different levels of development.

It made sense for a while – certainly when the MSCI’s index for the US and China used to move together almost in tandem. However, as Bloomberg’s John Authers recently pointed out, since China started to clamp down on the private sector in 2021, these indices have widely diverged¹. And as a consequence of China’s recent growth problems, does it even makes sense to treat EM as their own asset class anymore?

Sebastien Thenard, Senior Portfolio Manager, Emerging Market Debt at Paris-based Ostrum AM, said: “Seasoned EM investors are for sure frustrated with the term ‘emerging markets’. This term made sense at the onset when there were only six or seven countries to invest in, however, over the years, the universe has broadened out to include around 80 countries. Today, EM is clearly a term that could be misleading when a significant part of the universe is rated investment grade.

“So, yes, there is now debate as the term no longer does justice to the wide array of constituents within the various EM indices. In terms of country ratings for example, within the same index, you have China and some Middle Eastern countries which have very high ratings, along with other countries like Venezuela, who are still considered in default.”

It’s a similar story with ‘the BRICs’ – Brazil, Russia, India and China. Coined by former Goldman Sachs economist Jim O’Neill in an effort to rally investment around EM funds, that term has also largely outstayed its welcome – even after the addition of South Africa in 2011 to make it ‘BRICS’.

According to Rafael Ch, Partner, Senior Analyst, Latin America Emerging Markets, at policy and strategy consultants Signum Global Advisors, it’s time for EM to evolve.

He commented: “If you look at the last two to three years, it has become very evident for Latin American countries, that regional trade blocks are not that effective for advancing their economic agendas. And that includes CARICOM [the Caribbean Community and Common Market] and even the MERCOSUR [the Southern Common Market, comprising Argentina, Brazil, Paraguay, and Uruguay].

“The signal is that the BRICS do pose a more attractive type of block that they could either adhere to or grow closer to. Ultimately, in a multipolar world, multipolar blocs might be more tempting for emerging markets to join rather than traditional trade blocks at the regional level.”

Taking stock on EM growth

Problematic acronyms and nomenclature aside, there’s certainly renewed optimism for economic growth across EM, coupled with more stable fiscal environments and lower dollar-denominated debt.

Brigitte Le Bris, Head of FX and EM Debt at Ostrum AM, explained: “For many years, EM have been dependent on international flows. An investment decision started out with an analysis of the US dollar and an opinion on where we were in the global economic cycle. Today, there are notable endogenous forces within EM for investors to consider. Countries have matured and have become more autonomous, thus more financially independent, and therefore, less tied to the US dollar.

“Meanwhile, numerous EM now have local pension funds to finance their growing local debt issuance. All of which adds confidence to our view that the performance of the asset class can continue to outpace DM bond performance in the years to come.”

The opportunities are clear across EM equities too. Mike Tian, Portfolio Manager, Emerging Markets Equities at WCM Investment Management, commented: “We are bullish on consumer internet companies in EM, especially outside of China. We see strong secular growth, with relatively low levels of penetration, and increasing rationality. In almost every country, the winners and losers are becoming a lot clearer, and the winners are separating themselves from the pack.

“In the mid-term we are also very interested in South Korea’s ‘Corporate Value Up initiative’ [which aims to enhance the appeal of the South Korean capital market to investors by encouraging companies to distribute more dividends]. It’s early days, but we are seeing some companies embrace it and, if they prove successful and are rewarded in the market, we can certainly see this becoming a powerful theme."

Red-hot Indian equities

China’s recent launch of a broad package of monetary stimulus measures cheered the region’s subdued markets – at one point, the CSI 300 index of Shanghai- and Shenzhen-listed shares was up nearly 30% from its February trough².

But the jury’s out on whether there’s enough in the Chinese ‘big bazooka’ to tackle persistent deflationary pressure and an entrenched property crisis³. Indeed, Bank of America’s latest Global Fund Manager Survey found growth expectations for China at a record low, with a net 18% expecting a weaker Chinese economy⁴.

Conversely, Indian equities have performed strongly – India’s share of the free-float, ‘investable’, version of the MSCI All-Country World index, which tracks almost all global stocks that can be bought on the open market, rose to 2.33% in September, eclipsing China’s 2.06%⁵. A protracted downturn in the property market, tepid export demand, and subdued consumer spending are all weighing on China’s post-Covid economic recovery⁶.

Ashish Chugh, Portfolio Manager, Global Emerging Market Equities at Boston-based Loomis Sayles, thinks the biggest challenge for China over the long term stems from the real estate sector.

“We’ve seen this in other emerging markets and it takes many years for it to work out,” he said. “The Chinese government announced they are going to create a fund that’s going to buy up unsold property, but that’s not sustainable – it’s not the solution. Every time you build infrastructure and real estate it needs to lead to productivity improvement for it to create GDP growth.

“But they overbuilt, basically boosting GDP through the real estate sector, which makes up 40% of the economy⁷. And a large portion of consumer wealth is tied up in property assets. Related to that is the fact that real estate loans have stretched Chinese banks, which are 100% state owned.”

Meanwhile, India is projected to be among the fastest-growing major economies over the next decade, with GDP growth expected above 6%⁸. A third consecutive term for the ruling National Democratic Alliance – led by the Bharatiya Janata Party (BJP) and its leader, Prime Minister Narendra Modi – is expected to provide policy continuity and stability.

“By 2035, India will potentially become the third largest economy in the world, far bigger than Germany and Japan,” commented Mike Tian. “If current trends continue, it will also be much more relevant in global supply chains, as well as in geopolitics. The western world will likely be struggling to deal with India in the same way it struggles to deal with China today, which will be made harder by India’s increasingly assertive foreign policy.”

Next decade thinking

Investors will naturally be watching India and China particularly closely over the coming years. Yet we shouldn’t forget the other EM regions that have the potential to shift the global economic landscape.

“The big question for the next 10 years is will the Latin American emerging markets manage to solve the fiscal crisis?”, said Rafael Ch. “We're coming from the past 10 years of cheap money, with a sudden shock between 2020 and 2022 where money was no longer cheap. All of which made it evident that most emerging markets were in very tight fiscal positions. So, over the next ten years, can they continue to kick the can down the road or will they have to address this situation?”

Moreover, while much of the hype associated with artificial intelligence (AI) has been driven by one particular company in the developed markets, the real opportunity in AI from a long-term investment perspective could well be in EM.

For Ji Zhang, Senior Research Analyst at Loomis Sayles, this is largely due to increased computing power, higher storage, and applications that use AI for tangible purposes.

He explained: “When you think about increasing computing power, the world's leading semiconductor manufacturing – both in terms of technology, as well as manufacturing capability – is based out of Taiwan⁹. When you think about storage, the majority of the world's development for memory is based out of South Korea¹⁰. And when you think about development of new AI applications that are used in real life applications, much of the software development and architecture that's being concepted right now is coming out of Latin America and India.

“So, when you think about emerging markets for AI, you're not talking about companies that are hype type of companies. You're talking about many companies that may enjoy years and years of structural growth because they could be the true enablers of longer-term AI adoption.”

Certain challenges will need to be overcome, such as ensuring there’s the necessary internet and electricity infrastructure for AI to flourish. But these are not insurmountable. For the winners, there’s real potential to kickstart a golden decade of innovation and growth.

“In the next 10 years, AI will become much more developed than it is today,” added Mike Tian. “Middle-income EM countries will be wrestling with the implications of AI, which has the potential to prevent them from climbing the value curve, both on the services side and the manufacturing side.

“How they adapt to these new technologies will determine which countries are successful longer term. Failure to adapt will likely lead to poor growth, higher inequality, and social unrest. We will see some winners and losers emerge, and the winners will likely be the ‘new BRICS’ countries we are going to be talking about in 2035.”

Written in October 2024

Loomis Sayles, Ostrum AM, and WCM are all affiliates of Natixis Investment Managers, and form part of our Expert Collective.