Take yourself back to the aftermath of the most severe financial crisis since the Great Depression, 15 years ago. The financial world, crippled by a US-led credit and housing bubble, was being revived in part by an unprecedented £300bn Chinese-led stimulus plan. At that moment, one might have reasonably thought they were witnessing a historic shift in economic power, moving from the United States to emerging markets, with China at the forefront.
If this had been the basis of an investment strategy, it would have led to disappointment. For example, if you had invested £100 in an index of emerging market shares in September 2009, that investment would be worth £121 today. A direct investment in China would have fared worse, with that same £100 now valued at just £95. Conversely, if you’d placed your faith in a global stock market recovery, your initial £100 would have grown to £324. Those betting on a resurgence of American economic leadership would have seen their £100 swell to £539. It’s essential to remember, though, that past performance doesn’t guarantee future returns.
Since 2008, emerging market shares have been heavily de-rated. They currently trade at around a 35% discount compared to their developed market counterparts. Their overall weighting in global mutual funds has dropped from 13% in 2010 to just 5% today. The pandemic further exacerbated these challenges. Emerging markets have struggled with a strong dollar due to rising and sustained US interest rates. They have also been negatively impacted by China’s faltering economy and stock market performance since 2021. In addition, a general risk-averse sentiment among investors, coupled with increased geopolitical tensions, has weighed them down over the last three years.
The Federal Reserve’s recent shift towards a more relaxed monetary policy could signal a change. China’s stimulus package, while impressive, may still be insufficient. However, it suggests that global policymakers were waiting for the US to take the lead. The ingredients for a shift back to riskier investments, such as those in emerging markets, are now present, but the trigger was missing—until recently.
Higher US interest rates posed significant challenges for many emerging markets. Nations like Brazil, Poland, and Mexico had built credibility by raising their own interest rates ahead of the US Federal Reserve, aiming to control inflation. Last year, emerging market shares performed well in anticipation of lower borrowing costs, which would have supported local economies and attracted investment. However, the Fed’s decision to hold interest rates steady for most of 2024 stalled those plans as central banks feared for their currencies.
That all changed recently, and with markets now expecting further US rate cuts by the end of next year, emerging markets may follow suit. A soft landing is currently the base case scenario, with weak oil prices easing inflationary pressures. Investors can now turn their focus towards the better current account balances, foreign exchange reserves, and reduced borrowing costs in emerging markets. After 15 years of struggle, could investors finally be approaching a recovery?
The outcome will largely depend on two crucial factors: China and commodities. China, despite its recent economic weakness, still constitutes a significant part of the emerging market index. Unfortunately, it has been a drag on the investment class for years, primarily due to the persistent slump in its property market. With up to half of household wealth tied up in property, the collapse of the housing market has severely dented consumer confidence. The government’s slow and piecemeal approach to stimulus has done little to remedy the situation. While recent measures may improve liquidity, the key issue remains a lack of consumer willingness to spend, despite having the financial capacity to do so.
Moreover, China’s demographic challenges further complicate the outlook, with only nine million births annually compared to 12 million people entering the over-60 age group. Adding to this are concerns over a potential second phase of the US-China tariff war, making Chinese shares less attractive to investors. Their current average valuation is about nine times expected earnings—less than half the multiple seen in both US and Indian stocks. Companies like China Mengniu Dairy have seen their valuations plummet from 50 times earnings three years ago to just 15 times today.
Another factor tied to an emerging market recovery is the commodities market. The performance of emerging markets has historically been closely linked to the prices of key commodities such as iron ore and copper. While the long-term outlook for metals like copper is strong due to their role in decarbonisation, electric vehicles, infrastructure, and data centres, the short-term picture is bleak. China’s economic struggles and slowdowns in the US and Europe weigh heavily on commodity demand. The extent of these headwinds is exemplified by the drop in oil prices, which have fallen from $130 a barrel a few years ago to around $70 today.
Fidelity Emerging Markets Limited (LON:FEML) is an investment trust that aims to achieve long-term capital growth from an actively managed portfolio made up primarily of securities and financial instruments providing exposure to emerging markets companies, both listed and unlisted.
