Why the outlook for emerging markets is improving after years of underperformance

Emerging markets have underperformed over the past decade. Alex Rankine explains what the outlook is.

It has been a miserable decade for emerging market (EM) investors, says David Thorpe in FT Adviser. EM shares have returned just a third as much as the global average. And recent performance has not been encouraging: the combined market capitalisation of the 24-country MSCI Emerging Markets index has fallen $4trn since early 2021, say Srinivasan Sivabalan and Karl Lester Yap on Bloomberg. Rising US interest rates and slowing global growth are weighing heavily on the asset class.

EMs don’t look expensive now, but the US dollar is the sector’s “puppet master”, James Sullivan of Tyndall Investment Management tells FT Adviser. “Ascertaining the true value of a market that is intrinsically linked to a foreign currency is fraught with jeopardy.” A strong dollar makes it more expensive for businesses that borrow in dollars but earn in local currency to service their debts. There are plenty of those in emerging markets. “US dollar credit to non-banks outside the US stands at $12.6trn, which represents 14.8% of world GDP, up from less than 10% in 2007.”

The dollar could easily go higher from here and that may make for a “rather unpleasant outcome”. And it’s not just companies that need to worry about debt. Emerging market sovereigns have increased their borrowing to 67%, up from 52% pre-pandemic, says The Wall Street Journal. Now the bill for the borrowing binge is coming due. “Interest expenses as a percentage of government revenue, at some 10%, are the highest since before the 2007-2008 panic.” That set-up has triggered “countless emerging-market crises” in the past.

Learning the lessons

On the plus side, central banks and governments in most emerging economies have learnt their lessons from previous crises and look well prepared to cope with a period of dollar strength, says Kimberley Sperrfechter of Capital Economics.

Yes, there are a few countries with “fragile external positions” (meaning they rely on foreign investors to fund their trade deficits), such as Turkey, Chile and “a handful of central European economies”. However, they are the exceptions in the EM universe.

In any case, not all emerging markets are doing badly. Commodity currencies such as the Brazilian real and South African rand have performed well this year. Global investors have been piling into Indonesia, says Dave Sebastian in The Wall Street Journal: foreign institutions pumped $5bn into local equities between January and April, even as they pulled funds from elsewhere in emerging Asia. “Indonesia is the world’s largest coal exporter and a producer of other key commodities such as oil, gas, nickel and palm oil.”

This hints at a dilemma for investors. “Emerging market indices are dominated by a handful of larger markets,” says Theo Andrew on ETF Stream.

In particular, China accounts for more than 30%, leaving any fund that tracks the overall asset class exposed to the whims of Beijing. Index providers have started to roll out emerging markets ex-China products, but investors want to go further and move towards “different themes within emerging markets” rather than simple country classifications.

For more on this topic see:

The easy way to invest in emerging markets

Emerging-market investors turn cautious

Recommended

Persimmon yields 12.3%, but can you trust the company to deliver?
Share tips

Persimmon yields 12.3%, but can you trust the company to deliver?

With a dividend yield of 12.3%, Persimmon looks like a highly attractive prospect for income investors. But that sort of yield can also indicate compa…
1 Jul 2022
The MoneyWeek Podcast: nuggets of positivity in an extended bear market
Investment strategy

The MoneyWeek Podcast: nuggets of positivity in an extended bear market

Merryn and John talk about he need for higher wages and lower house prices, and why the fact that this is the least dramatic bear market they’ve ever …
1 Jul 2022
Here are the best savings accounts on the market now
Savings

Here are the best savings accounts on the market now

With inflation at more than 9%, your savings are not going to keep pace with the rising cost of living. But you can at least slow the rate at which yo…
1 Jul 2022
Don’t try to time the bottom – start buying good companies now
Investment strategy

Don’t try to time the bottom – start buying good companies now

Markets are having a rough time, so you may be tempted to wait to try to call the bottom and pick up some bargains. But that would be a mistake, says …
1 Jul 2022

Most Popular

UK house prices are definitely cooling off – but are they heading for a fall?
House prices

UK house prices are definitely cooling off – but are they heading for a fall?

UK house prices hit a fresh high in June, but as interest rates start to rise, the market is cooling John Stepek assesses just how much of an effect h…
30 Jun 2022
The ten highest dividend yields in the FTSE 100
Income investing

The ten highest dividend yields in the FTSE 100

Rupert Hargreaves looks at the FTSE 100’s top yielding stocks for income investors to consider.
22 Jun 2022
Gold has been incredibly boring to own – but that’s no bad thing right now
Gold

Gold has been incredibly boring to own – but that’s no bad thing right now

Stocks, bonds and cryptocurrencies have all seen big falls this year. But gold remains at its one-year average. It may be dull, but it’s doing what it…
29 Jun 2022