Should you invest in emerging markets?

Emerging-market (EM) equities have struggled to get the attention of investors over the past five years. Since 2020, the MSCI Emerging Markets Index has underperformed the MSCI Developed Market Index by a total of 45%, according to JPMorgan.

Virtually all of this gap can be attributed to the outperformance of the US and the underperformance of China. Chinese equities comprise 28% of the MSCI EM index, followed by Taiwan at 20%, although half of that is accounted for by Taiwan Semiconductor, which has a 10.5% weighting. TSMC is by far the largest holding and is more than twice the size of the next largest, China’s Tencent at 4.5% of the index.

Emerging-market stocks are cheap

The outperformance of the US equity market compared with the rest of the world since 2020 has driven relative EM valuations to multi-decade lows. The MSCI Emerging Market’s forward price/earnings (p/e) ratio now stands at a 40% discount to developed-market peers, the biggest differential since 2006. On a price-to-book value basis, EMs are trading at a gap to developed markets not seen since 2001. That is just the headline figure; the valuation dispersion among EM equities is enormous.

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According to JPMorgan’s analysis, Chile, Turkey, Poland, Brazil and Mexico are all trading at discounts of 30% or more to their two-decade average on a forward p/e basis. Korea and South Africa are trading at discounts of 20% or more. On the other hand, Taiwan, Thailand and India are the most overvalued markets. These markets are trading at premiums to their 20-year average of between 21% to 28% on a forward p/e basis, although for Taiwan, the figures are skewed by TSMC.

Despite these low valuations, emerging economies as a group are expected to grow faster than their larger, developed peers in 2025. Analysis conducted by specialist EM fund manager Ashmore suggests they will grow 3.9% as a group in 2025, more than double the 1.5% predicted for developed markets.

Asian economies will lead the charge, with growth of 4.4% pencilled in for 2025. Outside Asia, the Middle Eastern oil-power economies are expected to underpin growth in the Middle East/Africa region to 3.6% in 2025. Eastern European economies are expected to chalk up growth of 3%.

These figures are subject to a high degree of uncertainty, as we have yet to see how Donald Trump’s tariffs on key US trading partners influence trade. Earlier this month Trump imposed tariffs of 25% on all goods from Canada and Mexico (excluding oil from Canada, which will be hit with a tariff of 10%) and tariffs of 10% on China. At the time of writing, however, he has paused the levies on Canada and Mexico by a month.

Mexico has the most to lose. Exports to the US accounted for 25.2% of its GDP as of March 2024, making it the most exposed to any protectionist trade policies. China is actually one of the least exposed countries. According to Ashmore, just 2.7% of China’s GDP is tied to US exports. That’s not to say tariffs won’t have much of an impact on China’s economy. Any trade restrictions are likely to be deflationary and could drive the country’s policymakers to monetary stimulus or fiscal support to cushion the economic blow. The spillover effects of these policies could be a net positive for other emerging markets if the country unleashes its massive multi-trillion dollar fiscal surplus to save the economy.

The ultimate impact of a global trade war is difficult to determine, but that doesn’t mean investors should give up on emerging markets. In fact, tariffs are likely to hit the pockets of US consumers more than anything else, and in recent years many countries have made huge progress in shifting their supply chains to deal with more protectionist policies.

In addition, there is more to the world of emerging markets than the traditional plays such as China, Mexico and Taiwan. Regions such as Poland, Turkey and South Africa are likely to escape the worst of the trade war and could even benefit as supply chains are rerouted. They also look incredibly cheap by historical standards.

These factors, coupled with the fact that US equities are currently priced for a Goldilocks environment, imply that adding historically cheap EM stocks to a portfolio and reducing exposure to expensive US equities could make sense.

Are active funds better for investing in emerging markets?

When it comes to investing in EMs, active funds are usually the better choice. While passive funds are usually the best way for investors to build exposure to global markets, EMs tend to be less efficient, so there are more opportunities for outperformance with active fund management.

One example is the Ashoka WhiteOak Emerging Markets Trust (LSE: AWEM), which makes use of a team of in-country experts to pick stocks, which has helped it outperform. The trust offers an annual redemption facility for investors. The nature of EMs also means that investment trusts are often the best vehicle for investors to build exposure. The closed-ended nature of trusts means they can invest in illiquid securities, and EM exchanges are often far less liquid than their developed counterparts.

The JPMorgan Emerging Markets Trust (LSE: JMG) is another broad play on these fast-growing, undervalued markets. We also like the Templeton Emerging Markets Investment Trust (LSE: TEM). Also worthy of further research is the Utilico Emerging Markets Trust (LSE: UEM), which, uniquely in the sector, focuses on infrastructure and utilities in developing countries.

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