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.

High commodity prices mean a better outlook for Brazil.
(Image credit: © Getty)

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.

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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