We are pleased to share with you our RBC Emerging Markets Equity Outlook for 2024.

2023 has been a notable year for emerging markets (“EM”) equities, and potentially the beginning of their decoupling from developed markets. While we have seen continued underperformance of China, other EM have been performing well both in terms of fundamentals and equity market returns, with strong prospects looking ahead.

“ We cover a range of topics including macroeconomics, valuations, earnings, styles, themes and ESG reforms.”

In this year’s report, we reflect on key developments over the course of the last year and set out our thinking for the environment ahead. We also address the questions that have been top of mind for our clients. We cover a range of topics including macroeconomics, valuations, earnings, styles, themes and ESG reforms. While our portfolio positioning continues to be primarily driven by stock selection, we use this report to identify the extremes from a top-down perspective and increase or decrease weights at the margins.

We also review developments within our five portfolio themes. These themes help up position our portfolio in areas of long-term structural growth, which we feel is particularly important in the new environment of higher interest rates and lower growth. Importantly, our detailed research helps us identify the most attractive ways to play each theme from an investment standpoint, and we report on the updates we have made over the course of the year.

Given China’s significant weight in the MSCI EM Index and its continued underperformance this year, we dedicate a chapter to China, to assess the near-term drivers of this underperformance and our outlook for its path ahead. In particular, we review the four main concerns on China’s long-term growth trajectory: debt, deflation, decoupling, and demographics.

We also deep dive into our outlook for India where we are particularly constructive from both a top-down and bottom-up perspective, and Latin America where we are seeing positive developments and opportunities from geopolitics and commodity trends.

Summary

This year, a historic event has occurred which suggests that EM could finally be decoupling from DM. For the first time in the history of EM as an asset class, the market cap-weighted interest rate is lower than DM. Due to EM’s higher risk premium, central banks in EM have always maintained higher interest rates to prevent capital outflows and defend their currency. Additionally, EM governments maintained orthodox monetary and fiscal policies during the Covid-19 period and appear to now be reaping the rewards of this with relatively high real rates, lower inflation, and conservative fiscal deficits relative to history and DM. Despite the fastest rate hiking cycle by the U.S. Fed in its history, the lack of a material sell-off in EM equity and currency markets is very encouraging. We have also seen EM local currency debt significantly outperform DM over the last year.

Despite these significant developments, the performance of EM equities has been negatively impacted by weak performance from MSCI EM Index heavyweight China, with the country being the worst performer in EM in the last three years. Since the market’s strong outperformance during the Covid-19 era, China has seen a sharp decline, driven by several factors: regulatory uncertainty surrounding the technology sector, the impact of relatively tight policy particularly towards the property sector, and the negative impact of China’s zero-Covid policy on consumer confidence and growth. Looking ahead, we believe that the regulatory issues in the internet sector are now largely behind us, and that the much-improved valuation and expectation of government support for the economy and corporate sector are likely to drive improved equity performance. However, selectivity in China will remain key. In this environment it will be important to be cautious on areas that are vulnerable to negative government policies and to be positioned in areas that the government is likely  to support, such as renewable energy, consumption,  and independent technology.

Outside of China, a significant overhang for the performance of EM equities in recent years has been  US dollar (“USD”) strength. There are several reasons  to believe this may be about to reverse: a peaking in  U.S. monetary tightening expectations, a diminution  of international risks, and a rally that looks very extended both in terms of duration and degree. 

There is also a powerful case that EM currencies can perform well driven by both extremely cheap valuations, relatively high real rates and strong current accounts. Outside of currency, there are two key positive factors which should support EM performance over the medium term. 

Firstly, both earnings and relative EM growth look set  to improve from cyclically low levels driven by improved productivity, structural reforms and more growth-friendly fiscal policies. Secondly, the valuation case for EM remains strong, particularly relative to DM, following  the significant underperformance of recent years.

Despite the relatively disappointing index performance over recent years, there have been clear winners and losers. In this environment, active fund management with a strong focus on risk control is key.

In terms of styles, we believe that both Quality and Value look attractive from a valuation standpoint and that a higher rate environment can support both factors. At the same time, we believe there is a strong case for caution on Growth stocks which remain crowded and expensive and with deteriorating fundamental outlooks. We also believe that both higher dividend-yielding stocks and EM smaller caps, which have tended to do well over longer periods, look attractive. 

“ For the first time in the history of EM as an asset class, the market cap-weighted interest rate is lower than DM.”

We continue to be particularly positive on the outlook for India which is enjoying a long-awaited pick-up in private fixed asset investment, after years of underinvestment. Southeast Asia also looks robust as the region’s economies continue to recover post Covid-19, despite higher real rates, which are another testament to their improved fundamentals. In terms of valuations, China and South Africa look undervalued from both an equity and currency perspective, while India looks expensive relative to return expectations. In our view, however, India deserves to trade at a premium given the greater number of high quality stocks and its structural growth story, but the rich valuations and high expectations remind us to be extra mindful and disciplined when it comes to valuation. As a whole, EM looks very attractive versus U.S. equities, when comparing valuations and return expectations.

In terms of sector positioning, we favour domestic sectors driven by high returns and supportive tailwinds, such as rising incomes, positive reform momentum, attractive demographics, growing urbanisation and positive employment trends. Within cyclicals, we have a preference for financials on attractive valuations, improving asset quality, low penetration and  structural growth.