A shift in perspective: Why emerging markets deserve a second look

Why ignoring emerging markets might be risky?

Often viewed through the lens of volatility and political uncertainty, emerging markets (EM) can seem like an unpredictable ride. Recent events, including trade tensions between the U.S. and China, economic uncertainty in China, and higher interest rates in the U.S. have exacerbated concerns about these markets. With ‘US exceptionalism’ drawing in investor flows for many years and deglobalisation narratives on the rise, it’s no wonder investors are cautious.

Yet, avoiding these markets entirely could pose an even greater risk. As renowned investor John Templeton said, “Bull markets are born on pessimism, they grow on skepticism, they mature on optimism, and they die on euphoria.” For active investors, the current pessimism around emerging markets and the valuation dispersion within may in fact present a strong entry point.

Challenging conventional wisdom when thinking about EM

The idea that emerging markets are simply “too risky” overlooks the multifaceted nature of global trade, economic dynamics, and asset valuation. Over time, equity markets worldwide tend to deliver broadly similar annualized returns, with periods of outperformance and underperformance. And starting valuations matter to subsequent returns. Furthermore, what feels uncomfortable at any given time often proves to be more profitable thanks to the equity risk premium.

Today, the market-cap concentration in U.S. equities reflects past performance and presents risks for passive investors. U.S. companies now represent over 70% of global equity indices, while emerging markets account for only 10%. Given that 85% of the world’s population resides in emerging countries and contributes to half of global growth, this underrepresentation at the market level likely means that opportunities are being overlooked.

Valuations further support the case for investing in emerging markets. The MSCI Emerging Markets Index currently trades at a forward price-to-earnings ratio of 12.2x, a significant discount to the MSCI World Index. While it’s important not to treat these markets as a monolith, some of the disparities are striking—for instance, 80% of Indian stocks trade above 20x P/E, compared to only 20% of Chinese stocks.

Opportunities within the framework of deglobalisation

Despite widespread concerns about deglobalisation, its impact on global trade has been minimal so far, with only 2% affected—primarily due to Russian sanctions—as trade routes have adapted through intermediary countries and production has shifted to so-called ‘friendly’ regions. Intra-regional trade among emerging markets has also flourished, growing to $4.5 trillion by the end of 2023—an 80% increase since 2016. Countries like India and Indonesia are benefiting from urbanisation and demographic growth, while Latin American nations play a critical role in the renewable energy transition. Additionally, emerging economies in Eastern Europe and Mexico are gaining market share as decentralised supply chains evolve. Rather than collapsing, global trade is indeed reconfiguring, with emerging markets leading the way in a new phase of re-globalisation.

Resilience in times of volatility

Recent volatility in global markets has tested the resilience of emerging market assets, and the results are encouraging. During August 2024, concerns of a U.S. recession and currency fluctuations led to a sell-off in risk assets, but emerging markets held their ground. While some high-yielding currencies, such as the Brazilian real, weakened, others appreciated, reflecting diverse economic conditions across the asset class.

This resilience points to stronger fundamentals in emerging markets. With no signs of economic overheating and currencies trading at attractive levels, EM assets appear well-positioned to weather future market shocks. Moreover, undervalued and under-owned assets are less vulnerable to periods of market stress, and healthy corporate balance sheets offer fundamental support, giving global investors another reason to reconsider emerging markets.

A valuation discount with upside potential

Earnings from EM companies currently trade at a 45% discount to those of U.S. companies, reflecting investor skepticism. However, the earnings outlook for emerging markets over the next three years is bright, with expected annualised earnings per share growth of 15%, slightly higher than expectations for the S&P 500 Index. Past performance may not be a good guide to the future.

In addition to earnings growth, EM companies are increasingly adopting shareholder-friendly practices, such as share buybacks and dividend payments. Markets are rewarding these positive developments with higher valuations, as seen in the price recoveries of specific companies in Korea and China. This focus on shareholder returns, combined with strong corporate balance sheets, enhances the appeal of emerging markets.

The missed opportunity of ignoring emerging markets

Emerging markets are far from a monolithic story. While uncertainties remain, the diverse nature of these economies offers a range of opportunities, from demographic-driven growth in India and Indonesia to supply chain benefits in Asia and Latin America. Current valuations, earnings potential, and recent resilience in volatile markets all suggest that these markets deserve serious consideration.

For investors, the real risk may not lie in the volatility of these markets, but in the opportunity cost of staying on the sidelines. As companies across emerging regions continue to adapt and grow, they offer a valuable source of diversification and long-term returns—making them a compelling addition to any global portfolio.