This time last year, we were excited about the outlook for emerging markets in 2023 for three reasons: Firstly, it looked like a peak in the USD was rapidly approaching. There is a strong inverse relationship between the USD and emerging market equities, so this would benefit our asset class. This has more or less come to pass. Following 11 consecutive interest rate rises, US interest rates have been held steady at 5.25% for the last two Federal Reserve (FOMC) meetings. Inflation now appears to be under control. Since the last FOMC meeting at the end of October, the USD index has lost -3.5%. The MSCI EM Index has gained +7.7%. While it’s taken some time to reassure markets that monetary policy has worked, these are encouraging signs for EM equities from here.

Secondly, in December last year, China had just stumbled out of its last lockdown. The nation’s post-covid recovery was an exciting prospect, particularly the revenge spending driven by its $5.6tn of pandemic-era savings. It’s fair to say that this has not played out how most people would have guessed: After an encouraging start, geopolitics, the property sector, and battered consumer confidence conspired to leave China as the worst performing major equity market this year. The MSCI China index is not far off its covid-era lows, with the aggregate the cyclically adjusted Price-to-Earnings ratio (a measure of a company’s valuation relative to the long-term average of its earnings) at levels not previously seen since 2016. Valuations have been pummelled. Since 2000, Chinese companies have only ever been cheaper 4% of the time on this basis (Bloomberg, 2023). This is the world’s second largest economy, filled with a well-educated populace and world-class businesses against a backdrop of improving relations with the West and an increasingly effective series of policy nudges. And yet valuations remain stubbornly low. Have we reached peak pessimism? The fog surrounding China’s outlook is increasingly clearing, and while it hasn’t played out in 2023, we believe there are fertile conditions for a Chinese recovery over the coming 12 months.

Thirdly, we talked about the impressive growth differential between emerging and developed markets. This has also begun to pay dividends. While most developed economies have managed to avoid recessions in 2023, revised down IMF growth forecasts paint a fairly anaemic-looking 1-2% GDP growth future. Emerging economies, on the other hand, continued to grow through 2023 and now have the strongest relative headline lead indicators since June 2009; and, even including China, the aggregate EM purchasing managers index (PMI) is near its highest level ever. This already strong backdrop is overlaid with supportive EM central banks and attractive equity market conditions: For the first time in history, EM interest rates are forecast to fall below DM rates over the next 4 quarters (in aggregate). We have already seen some evidence of this in emerging equity market performance in the latter half of the year.

While it looks like two of our predictions have played out, how have these impacted the asset class? From first glance, EM equities have had a tough 2023, returning +5.8% to end November 2023 compared to the +20.4% investors would have experienced by holding the S&P 500 – a proxy for developed market performance. However, this is a slightly misleading comparison. Firstly it overstates both the positive impact of the “magnificent 7” US tech firms and the negative impact of China’s poor 2023. To understand how the majority of emerging markets stocks have performed against the majority of developed market stocks, it’s a more reasonable comparison to look at MSCI EM ex China index against the equally weighted S&P 500 index. Now how the tables turn. From this view, emerging markets ex China have returned +12.1% compared to +5.3% for developed markets. It’s clear that something is working here.

Turning our sights to 2024, we believe we have the most exciting coalescence of factors to support EM performance since the early 2000s. Our goldilocks scenario for 2024 is that (1) the US avoids a recession and (2) continues to print relatively low growth expectations in an environment where (3) global interest rates remain steady or begin to fall with (4) a weakening USD. Against this backdrop the relatively higher growth available to investors in EM becomes more obvious, leading to increased allocations to the asset class and greater support for asset prices. Research by Bank of America earlier this year showed that investors’ underweight to EM globally, relative to the allocation that would be suggested by the MSCI All Countries World Index, is at multi-decade lows. A return, even to the 20-year average level, would imply inflows into the asset class of more than $600bn.

Evidence of these three factors have already begun to emerge. The US ‘soft-landing’ looks like reality, with the country consistently reporting falling inflation and resilient employment. Secondly, the outlook for US growth appears muted, with the IMF forecasting 1.5% GDP growth for 2024. Higher borrowing costs, increased federal spending, and Federal Reserve Bank quantitative tightening makes the likelihood of an upside surprise, an increasingly unrealistic out-turn. Finally, with US interest rates at the highest level since 2007, the risk is low that there are more hikes from here. This should also see the USD continue to weaken, adding further support to the asset class going forward.