Staying Selective In Emerging Markets

Transcript

We like emerging markets as upbeat risk appetite carries on.

We see broader support for emerging market assets as markets price in a rosy macro outlook and fears of recession have faded.

But selectivity is key.

1) Broader support for EM

As markets have priced in rate cuts, 10-year Treasury yields have slid, narrowing the gap between them and hard currency emerging market debt yields. But spreads remain near the long-term average.

We like hard currency emerging market debt because it includes countries with higher-quality credit ratings and is often cushioned from any local currency weakness.

2) Staying selective

Emerging market stocks underperformed developed market peers last year, and that trend persists. China’s elevated equity volatility and policy uncertainty prompts us to take above-benchmark risk elsewhere.

3) Country-specific opportunities via mega forces

We find country-specific opportunities via the mega forces, or big structural shifts, we track like geopolitical fragmentation and demographic divergence.

For example, Mexico is increasingly acting as an intermediate trading partner between competing blocs. And India’s young, growing population stands out.

We stay overweight emerging market hard currency debt and neutral overall on stocks, but overweight Mexico and India equities.

In our view, structural shifts favor areas like infrastructure and real estate in multi-aligned countries like Mexico.

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We see broader support for emerging markets (EMs) given the market’s upbeat sentiment on risk assets as U.S. growth holds up, inflation cools and the Federal Reserve prepares to cut policy rates. EMs have been resilient to the latest Fed rate hikes. We get granular through mega forces – big structural shifts we see driving returns. We’re overweight EM hard currency debt on its relative attraction and quality, plus stocks in Mexico and India that are set to benefit from mega forces.

Better-priced

Notes: The orange line shows the spread for EM hard currency debt, using the JPM EMBI Global Diversified Index and based off U.S. Treasuries of similar maturity and adjusted for any credit enhancements. The yellow line shows the Bloomberg US Corporate High Yield Index, an option-adjusted spread. We look at the spreads relative to their 2000-2024 average.

We think the outlook for broad EM assets is supportive as market sentiment stays positive. Robust U.S. economic activity, nearing Fed rate cuts and falling inflation have lessened the market’s recession worries – a boon for EM. As markets priced in sharp Fed rate cuts, 10-year Treasury yields slid from 16-year highs near 5%. That helped tighten the gap between Treasury yields and higher hard currency EM debt yields. But spreads remain near the long-term average (orange line in the chart). U.S. high yield credit spreads are well below the long-term average (yellow line) – a sign of expensive valuations. We prefer EM hard currency debt and stay overweight. Along with attractive relative value, it includes more countries with higher-quality credit ratings than riskier high yield. Often issued in U.S. dollars, hard currency EM debt is also cushioned from EM currency weakness as EM central banks cut rates.

While we see broad support for EM assets ahead, selectivity is key because of the divergent performance across EMs. Overall, EM stocks underperformed DM peers last year, and that trend has persisted into the new year. China’s elevated equity volatility and policy uncertainty prompt us to take above-benchmark risk elsewhere. China’s share of the MSCI Emerging Markets index has edged down while the weight of countries like India has climbed, according to LSEG data. As we stay nimble with our views, we identify country-specific opportunities through the mega forces we track.

The mega force lens

Geopolitical fragmentation is one of five mega forces we see playing out now as competing geopolitical and economic blocs harden. Multi-aligned or “connector” countries like Mexico are increasingly acting as intermediate trading partners between blocs. The U.S. imported more goods from Mexico than China last year for the first time since the early 2000s, U.S. data show.

Demographic divergence is another mega force we track. Many EMs benefit from young, growing populations compared with aging populations in the U.S. and Europe. That’s one reason India – the world’s fastest-growing economy – stands out. India’s talent pool, start-up ecosystem and software firms with a global footprint also make it an up-and-coming hub for artificial intelligence (AI) software, in our view. Digital disruption and AI is a mega force we see being a key driver of corporate earnings. We think these drivers support the momentum of Indian stocks even as 12-month ahead valuations, while below their post-Covid peaks, are near their highest levels of the past 20 years. By contrast, those in Mexico are closer to the 20-year average.

These shifts from mega forces favor investment areas like infrastructure, in our view. For example, investment in EMs related to the low-carbon transition – a mega force – will likely be lower than in developed markets due to a higher cost of capital. We think closing the financing gap offers opportunities but will require public sector reforms and private sector innovation.

Our bottom line

We see upbeat market sentiment boosting EM assets and stay overweight EM hard currency debt on still-attractive yields. We’re neutral EM stocks overall. Within that stance, we are selective and overweight Mexico and India stocks. But we are monitoring a slew of elections in key EM countries this year, including in India, Indonesia and Mexico.

Market backdrop

U.S. stocks booked another week of gains, with the S&P 500 hitting a new all-time high as earnings beats have boosted sentiment and offset higher yields. U.S. 10-year yields climbed near 4.20%, up about 25 basis points from the start of the year. We think positive risk sentiment can run for a while as markets price in robust U.S. growth, cooling inflation and Fed rate cuts. Yet, we think still-elevated wage growth will push inflation back up beyond this year, preventing the Fed from cutting rates as much as markets expect. We think resurgent inflation will eventually become clearer and challenge sentiment.

We’re monitoring U.S. inflation data this week to gauge if falling goods prices will keep pushing inflation lower in 2024 as pandemic mismatches unwind. We think ongoing wage pressures in a tight U.S. labor market will put inflation on a rollercoaster beyond 2024. That’s why the Fed won’t be able to cut rates as much as the market still expects, in our view. In Europe, we look to GDP data for further signs of a divergence in growth among countries.