Back to the Future?

We have been through a lost decade in EM equities. From 2011 through the end of 2023, the MSCI Emerging Markets Index returned 1.6% annualized, while the S&P 500 delivered annualized returns of nearly 13%. 

Poor returns in EM stocks were caused by several forces. EM economic growth rates slowed down faster than expected and the US dollar strengthened, while valuations of EM stocks were high 10 years ago. Geopolitical turmoil within China and globally also added hurdles for EM stocks. 

It’s important to remember that looking in the rearview mirror and following consensus views isn’t likely to be a lucrative investment strategy. 

While the last decade was indeed disappointing for EM, in the previous period from 2001–2010, EM assets generated very strong returns of 15.9% per annum, whereas the S&P advanced by only 1.4% annualized. When that decade of EM leadership began, the outlook was bleak; we had just experienced the Asian financial crisis and the Russian default, while investors were energized by the rise of the dot-com companies in the US. Yet EM equities turned out to be a big winner because the asset class dramatically exceeded expectations. In other words, history suggests that a “lost decade” could set the stage for strong EM returns. 

So today, the key question for investors is: Where can we find assets that will beat expectations in the future? The pessimistic consensus view, confirmed by low valuations of EM stocks today, is a good starting point, in our view. Having said that, cheapness alone is insufficient criteria for investing in a stock. The question we ask as investors is, how can these companies positively surprise the market in the coming years? We believe investors can find unappreciated companies in EM offering attractive return potential that is uncorrelated to DM return patterns.

There are multiple drivers for EM companies today. These include innovation, reshoring and the potential of less-noticed Chinese companies to stand out.

Innovation will increasingly be an important ingredient for EM corporate profits. The share of patents originating in EM countries has been steadily rising over time, which we believe is a leading indicator for future innovation. Take artificial intelligence (AI) for example. NVIDIA in the US has grabbed the headlines, but the company’s role in the AI revolution is widely known. On the other hand, EM companies play an important role in AI innovation that investors are much less familiar with, so there is upside potential waiting to be discovered. 

For example, Asia Vital Components is a Taiwan-based manufacturer of heat-management systems for computers. Since the machines that run AI will use increasingly advanced semiconductors, chips will require electrons that are ever more densely packed. That means more heat is generated and overheating is a problematic, design-limiting constraint. Asia Vital’s products help address this issue with systems that can keep computers cool even at higher levels of heat generation. Many other suppliers of critical components will be needed for the AI revolution. Companies like these are what we call a “back door” to AI. Many of these manufacturers are based in EM countries and offer much more attractive valuations than some of the developed-world’s AI darlings. 

Reshoring is also reshaping the role of EM countries and companies in the global economy. Since China’s ascension to the World Trade Organization in 2001, China became the factory to the world. However, given rising labor costs in China and supply chain risks, multinational companies are increasingly diversifying their manufacturing footprint. This is known as the “China + 1” strategy. 

Key beneficiaries include emerging countries such as Mexico, Vietnam and Bangladesh. But the big question is India. Now the most populous nation in the world, India boasts an abundant low-cost labor pool. However, in the past, India never emerged as a manufacturing leader due to poor infrastructure and red tape. The government is proactively addressing these issues and multinationals are starting to shift production to India. Apple, for example, is building an AirPods factory in India, and has plans to continue ramping up production there in the future. 

Some investors worry about the slowing Chinese economy, which comprises 25% of the EM benchmark. Yet even in a more challenged environment, we believe there are many attractive opportunities to be found in China. The MSCI EM index includes over 700 Chinese companies. This diversity is an often-overlooked strength of EM broadly and of China in particular. 

New innovative companies are emerging, too. PDD Holdings, a rising Chinese online shopping company, for example, has been taking significant market share from the Alibaba Group. Many other new companies can be found below the radar screen of international investors. And some of China’s state-owned enterprises are becoming much more focused on return on capital and shareholder returns, which we believe could also drive upside surprises.

Clearly, risk must be even more diligently managed within EM. While country-specific issues are important, we think the biggest impact on EM performance will likely come from the US Federal Reserve and the US presidential election. Lower US rates should lead to a weakening of the US dollar, which is often positive for EM stocks. In addition, the China policy of the incoming US President can have a major impact. That said, both sides of the US political aisle agree on a policy of containing China, so we would expect status quo. If Donald Trump reenters the White House, however, more uncertainties are likely to surface, given his relatively tough stance on China in the past.  

EM central banks were generally early in raising interest rates during this cycle and EM economies have withstood rising rates very well. Lower rates should be a tailwind. In India, the 2024 election could be important for investors seeking signs of whether the infrastructure build-out and improvements in the ease of doing business that have taken root in recent years will be sustained. 

Low expectations for EM might seem like a deterrent for some investors. But in fact, we think low expectations can offer an attractive entry point for investors who have been underweight EM equities for some time. 

EM offers investors a world of choice, with more than 1,400 stocks to choose from within the benchmark and even more off benchmark. This provides ample opportunity for active investors to take differentiated, high-conviction positions versus the index. It’s especially important to focus on companies that offer improving fundamentals with a disciplined stock-selection process. Several themes could create catalysts for EM companies to surprise skeptical investors in the years to come.