An investment manager has forecast earnings from emerging market (EM) equities may outperform those of developed markets over the next few years due to a boost in global capital investment and anticipated interest rate cuts by the United States Federal Reserve.
Eastspring Investments head of global emerging markets Steven Gray pointed out investors have been cautious when allocating to EMs due to previous underperformance, however, the outlook for the asset class is now more optimistic.
“Emerging markets are very unloved at the moment and have de-rated considerably since 2010 from trading at a premium relative to developed markets to trading at a huge discount relative to developed markets,” Gray noted during a recent GSFM media briefing.
“While EMs have disappointed, that is priced into markets, so relative valuations are now very attractive to investors and expectations are low. EMs now represent an exciting value and diversification opportunity for investors as they often behave differently to developed markets.”
Analysis conducted by the firm suggests a cycle of increased capital expenditure, where companies invest in their own infrastructure, is currently occurring and will help to strengthen valuations for EM stocks.
“Emerging markets typically outperform as capital expenditure increases. Capital expenditure had been decreasing between 2010 and 2020, but since then we have started to see an increase in expenditure across both developed markets and emerging markets,” Gray noted.
“Historically there is a strong positive relationship between increasing capital expenditure and the performance of emerging markets, with markets outside China benefitting from increased exposure to materials, industrials and financials.
“We see several drivers such as the ‘great transition’ of supply chains away from China to other emerging markets, a greater focus on investing in decarbonisation and broad-based investment in infrastructure supporting stocks in real economy sectors across emerging markets.”
He believed cuts to interest rates towards the end of the year, driven by the US Federal Reserve, will also benefit investors who have allocated to EMs.
“The impact of a normalisation of interest rates is going to affect developed market earnings far more than it’s going to affect emerging market earnings. That’s one of the reasons why consensus earnings expectations for EMs in 2024/25 are actually higher than developed markets, which hasn’t been the case for quite a long time,” he said.
“Once the US federal bank pivots, the scope to reduce interest rates is actually bigger in emerging markets relative to other markets. This is especially true in Latin America, specifically Brazil and Mexico, where real rates are very high.
“The combination of the capital expenditure and interest rate cycles is boding very well for the performance of emerging markets relative to developed markets in the short term and over the next three to four years.”
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