Emerging markets versus developed markets

The outcome is likely to be decided by the relative strength of China versus the US, the most significant parts of emerging markets and developed markets, respectively.

Investor predictions of a better outlook for emerging markets in 2023 have yet to materialise. When China relaxed its Covid rules in 2022, it was widely expected to follow the pattern of Western economies in 2020 and 2021, where rapid recoveries ensued. All the building blocks were in place - excess savings, pent-up demand, sympathetic policy.

Furthermore, it looked like there could be some weakness in the US dollar as the US came to the end of its interest rate hiking cycle. This would have given emerging markets a boost. Also, valuations looked particularly cheap relative to developed markets. Many global asset allocators were already significantly underweight, so there was scope for a revival in flows.

However, China’s revival did not materialise with the hoped-for vigour. The Chinese Government made tentative efforts to support growth by implementing looser monetary policy, but fell short of expectations. Chinese consumer confidence remained low, suggesting the shock of the pandemic had been more profound than many realised.

In contrast, the US continued to defy inflationary pressures and higher interest rates to deliver economic growth ahead of expectations. The ‘higher for longer’ scenario on interest rates has helped keep the dollar high versus other major currencies, along with inflation falling more rapidly than in the eurozone. This helped the relative outperformance of developed markets.

Emerging markets continue to retain some advantages. Our 10-year expected returns for emerging markets are notably higher than for developed markets, thanks to higher dividend yields and expected long-term inflation. Investors can pick up that growth at more attractive valuations. Emerging market economies look set to grow faster than their developed market peers, supported by lower levels of debt.

There is significant contrast between the US and China on inflation. The US continues to run the risk that inflation is stickier around current levels. China has the opposite problem and is currently flirting with deflation. This can deter consumer spending, though our expectation is for this in 2024.

Developed market monetary policy is expected to ease gradually. Over the next 12 months, it could provide a for economies. However, markets may still be too optimistic on the extent to which the US Federal Reserve will cut interest rates from here. If inflation returns, interest rates could rise further.

In China, increased, giving a boost to economic growth. However, the Chinese Government continues to have concerns about excessive debt in the property sector. A larger stimulus would be a major boost for emerging markets, but this remains unlikely.

US monetary policy tends to impact the outcome for the dollar. There is still a gap in interest rates between the Federal Reserve (5.25%) and the European Central Bank (4%). This could be supportive for the dollar. Investors’ risk appetite is likely to be neutral if the US avoids a hard landing but sees growth roll over. On the other hand, the US needs to finance a large current account deficit. It’s a murky picture. The dollar’s trajectory remains hard to forecast, particularly in the short term.

There is little doubt that valuations are lower in emerging markets, particularly in China.

There are certainly structural and sentiment headwinds for emerging markets and China in particular, but this is largely reflected in stock market valuations. The US presents a mixed picture of robust growth but with inflationary concerns. The direction of the dollar will be important, but emerging markets are expected to deliver better earnings growth. Right now, the risks and potential rewards seem evenly balanced.

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