Q: After a period of underperformance, EM (emerging markets) equities have started to perform better relative to DM (developed markets) equities. Can this improved performance be sustained? What are the main drivers?

EM equities remain underowned and undervalued, and we forecast a volatile period in the aftermath of the U.S. election. However, over the next 12 months, we have a positive outlook on both the absolute and relative performance of EM equities. Over the past few years, many headwinds have led to EM equities’ underperformance relative to DM, but we believe we are now at a turning point and the challenges are turning into opportunities. We highlight the key tailwinds for the asset class below. Despite this positive outlook, EM equities currently trade at a historically wide discount to DM.

A weaker U.S. dollar (USD): There is an established negative relationship between the performance of the USD and EM equities. Following the U.S. election, we have seen the USD strengthen but we believe this is likely to be short lived. Several factors support a weaker currency going forward. In particular, we would highlight lower U.S. economic growth and rates, and the country’s large twin deficits. The valuation case is also compelling, with the USD looking overvalued relative to its own history, other currencies, and the U.S. economy’s fundamentals. Meanwhile, EM currencies have proved resilient in recent years, and we believe this improved performance can continue, given strong fiscal and trade account balances across many EMs.

“One result of the early tightening by many EM central banks has been peaking interest rates, falling inflation and attractive real yields on offer to investors.”

China’s performance is improving: Secondly, China, which represents a sizeable weight in EM equity benchmarks, has started to recover following several years of weakness. Despite the recent rally in Chinese equities, investor positioning and equity valuations remain at extreme lows. Meanwhile, history suggests there may be more market upside ahead. The three major stimulus-led rallies since the launch of the Chinese onshore CSI 300 Index in 2005 resulted in trough-to-peak gains of over 50-100%¹.

Favourable growth outlook for EM countries: EM economic growth is becoming much more widespread and less dependent on China. Over the long term, there is a strong correlation between the relative GDP growth and relative equity market performance of EM and DM. Following a period of narrowing, the EM-DM growth differential has begun to widen and is expected to expand further in 2025, supported by robust economic growth across many EM countries and weaker growth in the U.S. In coming years, EM countries are expected to account for 70% of global GDP growth².

Improving earnings growth from EM corporates: There are also positive developments with regards to earnings growth, another important determinant of the relative performance of EM and DM equities. For the last few years, earnings per share (EPS) growth has been lower in EM than DM, on aggregate. However, this is now changing. EM equities are forecast to deliver higher EPS growth than DM in both 2024 and 2025, which should prove supportive for share price performance.

EM country fundamentals are in good shape: EM fundamentals have improved considerably in recent years, driven by economic reforms and prudent monetary and fiscal policies across many countries. A result of this is superior current account and fiscal positions relative to history and the developed world. Notably, the U.S. current account deficit is near its worst relative to EM over the last two decades, while the U.S. fiscal position is also weaker compared to EM. As a result, there has been a structural shift down in EM policy rates and, for the first time in history, full convergence with DM rates. This positions EM well in an era of monetary easing, given high real rates and contained inflation.

The asset class is becoming more attractive: The EM equities universe is becoming more attractive, with increasingly diverse country exposure and less cyclical stocks. We are seeing growing exposure to areas of structural growth, including consumer, technology, and green infrastructure, with a much broader choice of high-quality franchises than has historically been the case. Despite this, the asset class is trading amongst its highest ever valuation discount to DM equities.

Q: The USD has benefited from an unprecedented bull market in terms of both length and extent. What is the case for a weaker currency going forward?

Historically, there has been a strong inverse relationship between the USD and EM equities performance. The unprecedented USD gains of the last decade have therefore presented a key headwind to the performance of EM equities during this period.

“Following over a decade of powerful performance, the USD looks extended and has not been this overvalued for 20 years.”

While we expect volatility in the immediate period following the U.S. election, we believe there is a strong case for USD weakness going forward.

In the short term, lower U.S. economic growth, inflation, and interest rates are likely to present headwinds for the U.S. currency.

Longer term, factors such as relative current accounts, debt ratios and fiscal positions matter. The U.S. current account deficit is near its worst relative to EM over the last two decades, while the U.S. fiscal position is also weaker compared to EM, which should be supportive for EM currencies.

This fundamental picture contrasts with valuations. Following over a decade of powerful performance, the USD looks extended and has not been this overvalued for 20 years.

Another important factor is that EM trade is decoupling from the developed world. Intra-EM trade continues to grow rapidly, with 45% of all EM exports now going to other EM countries³. This has positive benefits for EM economies as it lowers their correlation to the DM economic cycle and on USD funding requirements, reducing their vulnerability to U.S. interest rates and currency strength.

Q: What is the outlook for inflation and rates in EM? With the U.S. Federal Reserve commencing rate cuts, how is this likely to impact EM?

The EM monetary easing cycle is set to accelerate and broaden in 2025, with many central banks across both Asia and Latin America expected to join those that already started cutting in 2024.

Inflation has now fallen significantly and is well within central banks’ target bands across all developed and most emerging world countries. This is an important pre-requisite for EM central banks to start easing.

“The combination of lower inflation and U.S. Fed easing has led to expectations for virtually all EM central banks to cut rates in 2025.”

Despite high real rates, many EM central banks held off from cutting rates before the Federal Reserve (Fed), as this could have pressured their capital accounts, currencies, and also potentially impeded inflation from falling to the target bands.

The combination of lower inflation and U.S. Fed easing has led to expectations for virtually all EM central banks to cut rates in 2025. What we have seen historically is that an accommodative monetary policy environment is typically consistent with positive EM equities performance.

Q: What is your outlook on China following the recent stimulus announcements? Is it enough to sustain the recent equity market rally?

After months of poor economic data and declining equity markets, in September 2024, China’s leadership surprised markets by announcing a new stimulus policy package to boost economic growth. Notably, President Xi Jinping chaired a Politburo meeting for the first time in 12 years and the language used signaled a more understanding approach to the country’s slowing growth and property crisis. While previous stimulus measures have disappointed, this time the political signals pointed to a more sustained effort, resulting in a sharp equity market rally.

We also saw in November details of a highly anticipated fiscal package be released. The main news is that the government will issue RMB6 trillion (US$835 billion) of bonds to repay ‘hidden’ off-balance-sheet local government debt in order to address the cashflow crisis amongst local governments. However, there was no substantive fiscal stimulus attached to this debt swap plan, which disappointed investors judging by the market reaction. Policymakers did instead reiterate that other measures are on the way in 2025 and mentioned that the central government balance sheet remains strong and could fund further fiscal stimulus.

Our view is that the Chinese government’s notable shift towards supporting the economy is a welcome development after several years of heightened regulations and private sector scrutiny, which ultimately led to the collapse in confidence and equity market declines.

Despite the initial equity market strength, valuation remains supportive relative to history and other EMs. Longer term, there have been five major market rallies since the launch of China’s onshore CSI 300 Index in 2005. Of these, three were driven by stimulus with trough-to-peak gains of over 50-100%. If we are now at the beginning of another such rally, this suggests potential for considerably more upside ahead. Any evidence of fiscal support towards households and domestic demand rather than the supply side would prove supportive to this case.

“We continue to focus on high-quality Chinese companies operating in areas of structural growth aligned with our portfolio themes and government policy.”

What is surprising is that despite the weak economic data, Chinese corporates continue to deliver robust earnings growth and improving return on equity (“RoE”), suggesting a broader improvement in corporate governance and capital allocation in the market.

While China still faces considerable long-term structural challenges, including high debt, poor demographics, weak demand, and the global de-coupling of supply chains, we believe valuation levels and government support can support the market in 2025. We have gradually closed our structural underweight to China over the last two years, from a peak underweight during Covid, when Chinese stocks were extremely overvalued, to near neutral today.

We continue to focus on high-quality Chinese companies operating in areas of structural growth aligned with our portfolio themes and government policy. These names were indiscriminately sold during the weakness in recent years and became notably undervalued, in our view, despite resilient fundamentals. We continue to avoid low-quality, cyclical areas such as state-owned enterprises where there is limited scope for profitable growth.

Q: Given rich equity valuations, how do you view India currently?

India has been the success story of EM in recent years, driven by Prime Minister Narendra Modi’s reform agenda, which has successfully removed historic bottlenecks, improved the ease of doing business, and propelled India’s economic and political position onto the global stage.

We continue to consider India as one of the most attractive, long-term growth opportunities across EM, with many underpenetrated areas, low urbanization rates, a vast consumer base, and an array of best-in-class corporates. However, the last two years of extraordinary equity gains have left valuations in certain segments of the market looking extremely stretched. In particular, returns have been concentrated in small and mid-caps and within certain CapEx-driven sectors, notably Industrials, Real Estate and Autos.

The exceptional market gains have been fueled by local investors, with over US$2 billion flowing into domestic mutual funds each month⁴. Conversely, foreign investors have been reducing their exposure to the Indian equity market and are currently on aggregate underweight.

Overall, our feeling has been that the Indian equity market is due a correction, given extreme valuations in certain segments where we have been cautious. We continue to be positive on the long-term structural case for India and believe its growing weight in EM equity benchmarks is positive for the asset class.

However, in the near term, we remain cautious on India due to valuations. Most recently, we have started to see the market underperform, led by the most expensive segments which we have avoided. We continue to find relative value in certain pockets, notably large cap companies and Financials, where we have been rotating our exposure.

Q: What is your outlook on Latin America given weak recent equity performance and political uncertainty?

We have long been of the view that the Latin America region is home to many high-quality companies with strong management teams. Top-down considerations have always been important in Latin America and, in particular, risks stemming from the political front have been worth monitoring.

2024 has been a year where political stress has dominated the agenda. Despite having some of the highest real rates globally, Latin American countries are among the worst performing in EM year-to-date, in large part due to political risk in Brazil and Mexico. Trump’s election victory in the U.S. also has important implications for the region. The Brazilian equity market tends to have a negative correlation to U.S. bond yields, so it will be important to watch the policies of the new U.S. administration. Additionally, while longer term, we see Mexico being a key beneficiary of nearshoring and the relocation of global supply chains, any potential changes in trade terms between Mexico and the U.S. are likely to create volatility.

Following the underperformance of Latin America this year, the valuation of the region currently looks attractive. Longer term, we believe the region is a beneficiary of global supply chain shifts and strengthening commodities.

One of the key positives we see for Brazil longer term is the country’s leading position in soft commodities. Brazil is the world’s largest exporter of many soft commodities, such as soybeans, corn, coffee, sugar, beef, and chicken⁵. It is also one of the largest exporters of ethanol and cotton. Going forward, Brazil’s strong exporting position should benefit its global trading position and current account.

While there are a number of shorter-term risks to monitor in Mexico, we still think that the long-term nearshoring story is intact. Mexico has continued to gain market share in U.S. imports from China, more so than any other country, and we still think this could continue, as the narrative of the U.S.-China trade war is likely to be the most important focus for the new U.S. administration. Should nearshoring continue in the long run, this would be something that could significantly lift Mexico’s foreign direct investment (“FDI”) and GDP growth.

Q: The Middle East is becoming an increasing weight in EM equity benchmarks. What are your thoughts on the region?

The Middle East’s weight in EM equity benchmarks has grown considerably in recent years, to almost 7% of the MSCI EM Index currently, as regulators loosened rules and companies eased foreign ownership restrictions to make it easier to invest.

Within the region, we identify a particularly interesting top-down story in Saudi Arabia, driven by structural reforms and investments. Since his rise to power in 2015, the Crown Prince Mohammed bin Salman (“MBS”) has implemented a series of reforms under the banner of Vision 2030. These developments are transforming the kingdom and its trajectory of economic growth. Through three overarching goals of Ambitious Nation, Thriving Economy and Vibrant Society, Vision 2030 seeks to accelerate economic growth and reduce the kingdom’s reliance on fossil fuels. Material progress has already been made on both the economic and social fronts. For example, the share of the non-oil economy has grown to over 50% of GDP⁶, led by digital, green energy, talent development, population growth, and tourism, while on the social front, female workforce participation has increased to 35%⁷, already ahead of its 2030 target of 30%. Meanwhile, Saudi Arabia is set to be one of the key contributors to global GDP growth in coming years⁸.

Despite these positive developments, Saudi Arabia remains poorly ranked when it comes to ESG and human rights, and many investors would like to see further progress in these areas before meaningfully increasing their exposure. Currently, the market is largely domestically owned. We too are assessing ways to gain exposure to this attractive structural growth opportunity. However, most companies do not yet fully meet our criteria when it comes to the quality of the management and franchise, as well as disclosure and transparency, and the durability of business practices. The market is also currently expensive relative to other EMs.

Q: What is your outlook on technology following stellar returns from AI-related stocks? Can this strong performance continue?

While there is little doubt about the structural growth offered by AI, the performance of stocks related to this theme has become extended. As a result, we have gradually been reducing our exposure to AI-related stocks this year on strength, from an overweight position to a near neutral position currently.

Given that AI-related demand and CapEx remain strong, and there are no signs of earnings downgrades, investors could continue to chase these stocks higher. However, we believe there are several factors that warrant caution:

Magnitude and speed of equity gains: Since the start of 2023 to the time of writing, Taiwanese equities have rallied 85%, led by a 150% increase in chipmaker, Taiwan Semiconductor (“TSMC”). In South Korea, SK Hynix, the main memory supplier for Nvidia’s GPUs, has gained 220%. In the U.S., Nvidia’s share price has gained 800% over the same timeframe⁹.

Valuations: Most of the AI supply chain is located in Taiwan, where approximately 85% of the market cap is in technology-related industries¹⁰. The valuation of the MSCI Taiwan Index looks very stretched relative to history and the rest of EM.

Breadth: In both EM and DM, we have seen extremely narrow market leadership driven by a handful of tech stocks. This is also leading to higher benchmark concentration.

AI monetization remains unknown: The capital expenditure of U.S. hyperscalers is expected to more than double, from USD366 billion in the four years to 2021 to approximately USD750 billion by the end of 2025¹¹. However, many question marks remain, including around the expected margin profile of newer GenAI solutions, the split of investment between the training of models and inference, and the re-usability of training CapEx for future inference capacity. This poses a risk to the continuation of the current earnings cycle for AI stocks.

If we were to see further weakness within tech, our feeling is that EM would be in a relatively better position than DM. In terms of IT sector valuations, EM trades at a significant discount to DM.

Q: What implications do you expect from the U.S. election outcome?

While there are various factors at play, we would highlight China relations and global trade as the key considerations for EM investors when considering the implications of a Trump presidency.

On China, our view has always been that relations with the U.S. will remain fraught, regardless of the election outcome. We do, however, feel that Trump may turn out to be marginally less negative for China relative to the Democrats. In our view, Trump is more concerned with negotiating agreements and far less ideological, hence his regulations may be simpler for China to live with than the prior Biden administration, where the focus was on technology restrictions. Trump agreed a trade deal with China in January 2020, and the hope is that he will also be willing to negotiate this time around.

In terms of global trade, Trump is proposing 10% universal tariffs on all countries that sell to the U.S. and 60% on Chinese goods. However, despite the rhetoric, it is uncertain whether he will go ahead with such measures. If he were to do so, it would conflict with his stated objective for a weaker USD. Additionally, the U.S.’ weak fiscal position will constrain Trump’s ability to push through large reforms, given a fiscal deficit and government debt representing 7% and 122% of 2024 GDP respectively¹².

It is also worth noting that the impact on Chinese exports since the U.S.’ imposition of 20% tariffs on certain goods in 2018 has overall been limited, with China growing its exports to other superpowers, such as India and Saudi Arabia. More broadly, we have seen rising intra-EM trade, which has overall reduced EM countries’ dependence on demand from developed nations, notably the U.S. Currently, 45% of all EM exports are directed to other EM countries, and we expect this portion to continue to grow¹³. However, within EM, some countries and companies will be more vulnerable to U.S. tariffs than others, hence selectivity remains key.

Longer term, we are seeing global supply chain shifts, which are benefiting many countries across EM. We continue to view Mexico as a key beneficiary of the U.S. nearshoring theme, while India and Southeast Asian economies, such as Indonesia and Vietnam, are attracting increasing foreign investment as companies look to diversify supply chain risks.

We have not made any changes to our portfolios as a result of the U.S. election. Rising geopolitical risks and uncertainty reinforce to us the importance of investing in high-quality companies benefiting from structural domestic growth drivers. Where we do have exposure to exporters, our focus is on companies selling to other EM countries and those offering differentiated, higher value-add products and services.