EM spring: A brighter season for emerging market stocks may be ahead

The performance of emerging market (EM) equities primarily depends on two factors, China and the US dollar (USD), both of which have been considerable headwinds for EM investors for a long period of time. However, in our view, we are likely at an inflection point that could usher in the start of another structural bull market in EM equities. Below, we detail the case for China and the case for a weaker US dollar.

The case for China 

The case for China hinges on the convergence of a few factors. 

• First, we expect to see a progressive Keynesian response to the post-pandemic collapse in domestic consumption. The fiscal stimulus, alongside significant restructuring of the domestic economy and increased commitments to address economic vulnerabilities, should aid in reducing the structurally high level of excess savings in China. In turn, this should reduce the considerable imbalances in China’s economy and result in a powerful cyclical recovery in domestic consumption. 
• Second, we would not be surprised to see structural changes in the political-economic context in China, abetted by both internal and external pressures, namely that China will increasingly have to rely on domestic demand for growth amid growing trade tensions across the world. As a result, we expect growth in China will be lower but more sustainable and led by domestic consumption. 

Chinese equities remain both significantly undervalued and deeply under-owned, in our view. We believe that foreign investors will eventually be lured back in the wake of stabilization in economic growth. Additionally, in the past five years of economic turbulence, China has accumulated over US$41 trillion of liquid bank assets with near-zero yields, which we believe will shift into higher yielding/higher growth equities.¹ This implies that next pain trade in China could be very powerful and long-lasting.

The case for a weaker US dollar

The concept of “American exceptionalism” as it relates to the US equity market has been, well, truly exceptional. After a period of significant outperformance with more than 10% annualized excess returns versus EM stocks over the past three, five, and 10 years, US equities are broadly overvalued at a 40% premium versus EM equities and deeply over-owned by both international and domestic investors.²

The recent retreat in confidence in US cyclical economic growth (as evidenced by the recent moves in US long-term bond yields), elevated earnings expectations, and the uncertainty created by early Trump administration policies are unearthing broad concerns globally, reminding investors of both structural US vulnerabilities and elevated multiples. The US dollar, which appears to be overvalued on nearly all measures, is at the heart of the issue. The USD’s role as the reserve currency of the global monetary system has become extremely problematic to both US policymakers and their international counterparts.

The USD reserve currency status conveys enormous advantages including affording the US the lowest cost of capital globally, the deepest financial markets, and a dominant financial services industry. All of these have embellished the country’s relatively unique risk-taking culture and its ability to invest in the frontiers of science and engineering. The reserve currency also enables policymakers to act with relative impunity in fiscal and monetary policy, which has proven an enormous asset in mitigating the stresses of financial crises and moderating economic recessions. 

However, the reserve currency also conveys considerable competitive and distributional liabilities, which have cumulated over decades. By default, the global reserve currency must provide global liquidity. This implies that the United States must run large and growing current account deficits, which were arguably more easily digested when surplus countries recycled their claims into US Treasuries. Over the past 10 years, however, the surpluses have been increasingly redirected into ownership of US real assets and, more significantly, the US stock market. This, along with concerns about fiscal sustainability in the US ($30 trillion of US fiscal debt has been added in the past quarter century³) and geopolitical tensions have been large explanatory variables of the “US exceptionalism,” where US equities hover near 70% of worldwide stock market capitalization.⁴

Another challenge for the USD is that the United States is broadly uncompetitive in tradeable goods, and that is unlikely to change meaningfully in the near- to medium-term. Forty years of globalization and the resulting hollowing out of US industrial capacity, along with the ascendency of the USD reserve currency, have reoriented the US workforce towards services. It will take many, many years (if we ever get there) to re-industrialize, with all requisite investments in talent, skills, and supply chains.

Ultimately, addressing the unintended consequences of the USD’s role as a reserve currency will take more than aggressive trade policy. A weaker dollar, if not a coordinated devaluation, and attempts to force economic restructuring of industrial Asia (higher domestic demand, lower savings) are requisite. These will likely be complemented by efforts to shift residual USD surpluses from portfolio investments towards direct foreign investment in the United States. 

Our thesis on EM equities

We believe that the Invesco Developing Markets fund is well-positioned for both a structural revaluation of Chinese equities and a weaker USD environment. We are increasingly bullish on Chinese equities. In addition to the potential for beneficial fiscal policy, China’s leadership has clearly been mending bridges to the private sector, which has witnessed a considerable retreat in animal spirits over the past few years. These moves will likely compound as China, like its neighbors, increasingly needs to depend on domestic rather than external demand for growth. The high-quality private companies that we own in China have been benefitting from a more disciplined competitive environment, improved capital allocation, and growing free cash flow. These include internet companies that are direct beneficiaries of the increased adoption of artificial intelligence, ones that are expected to profit from increased domestic consumption and ones that are on the cutting edge of drug development. 

Outside of China, a lower USD and lower USD rates are of critical importance to reflating stubbornly low growth in Latin America, Southeast Asia, and to some extent India, where high real rates have sapped cyclical growth potential. Our holdings in these markets have suffered under the weight of a challenged macroeconomic environment and are deeply undervalued despite their attractive fundamentals. Therefore, a weaker USD could provide a tremendous catalyst for performance. Additionally, stronger currencies in Northeast Asia, which accounts for 60% of the MSCI Emerging Markets Index, could have positive USD return implications for EM investors.⁵