Indrani De, CFA, PRM,
Zhaoyi Yang, CFA, FRM,
- Investors have traditionally considered emerging markets (EMs) a riskier investment opportunity set than developed markets (DMs).
- But the risk-return characteristics of EMs may be changing, as reflected recently in compressed EM sovereign spreads and realized equity volatility in line with that of DMs.
- With healthy growth rates and better equity market performance in EMs outside China, the EM equity index is becoming more diversified.
- Investors may be getting more attuned to these shifts and pricing them into financial markets, which could create tailwinds for EM returns.
Investors have traditionally considered emerging markets (EMs) to be riskier than developed markets (DMs). History suggests that when the US Federal Reserve and other DM central banks raise their policy rates, capital flows out of EMs, creating financial stress. This was certainly true during the 1995 Mexican Peso crisis and the late-1990s Asian Financial Crisis, but what if those beliefs are now outdated? Recent data point to significant changes in EM fixed income and equity markets.
EMs remain resilient during recent DM hiking cycle
Exhibit 1: EM 7-10 year sovereign yield spreads versus key G-7 countries (bps)
Source: FTSE Russell and LSEG. Monthly data from February 26, 2021 to March 31, 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Exhibit 2: Equity volatility in EMs and DMs (%)
Source: FTSE Russell and LSEG. Monthly data from January 31, 2019 to March 31, 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
In general, EMs have been growing faster than DMs. What is also changing is that EMs are becoming more diversified. EM growth is not as dependent on China as it used to be, as countries like India, Brazil, Mexico and many others have entered a period of faster growth following structural reforms, as well as benefiting from the post-Covid supply chain diversification by DMs (Exhibit 3).
Exhibit 3: Economic Growth in EM & DM (%)
| EM | China | India | Brazil | Mexico | DM | |
|---|---|---|---|---|---|---|
| 2019 | 3.6 | 6.0 | 3.9 | 1.2 | -0.3 | 1.7 |
| 2020 | -1.8 | 2.2 | -5.8 | -3.3 | -8.7 | -4.2 |
| 2021 | 6.9 | 8.4 | 9.1 | 5.0 | 5.8 | 5.6 |
| 2022 | 4.1 | 3.0 | 7.2 | 2.9 | 3.9 | 2.6 |
| 2023 | 4.1 | 5.2 | 6.7 | 3.1 | 3.4 | 1.6 |
| 5-year annualised | 3.3 | 4.9 | 4.1 | 1.7 | 0.7 | 1.4 |
| 2024 forecast | 4.1 | 4.6 | 6.5 | 1.7 | 2.7 | 1.5 |
Source: IMF, FTSE Russell and LSEG. Data as of March 31, 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
In line with faster economic growth, the EM equity index has seen faster corporate earnings growth as well, which analysts expect to continue. Exhibit 4 shows IBES two-year earnings growth estimates for the Developed and Emerging indices, which have ticked up recently. (For a detailed discussion of these trends, see our latest Asset Allocation Insights, available here.)
Exhibit 4: Corporate earnings growth in EM & DM (Two-year estimate, %)
Source: FTSE Russell and LSEG. Monthly data from January 31, 2019 to March 31, 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
China’s growth model could be evolving
To understand the EM story, investors need to dig deeper into the changing economic model in China, which had previously dominated EM growth. The annual growth rate of China’s gross domestic product (GDP) has decelerated during the last two decades (Exhibit 5), from an average rate of over 10% during 2002-10 to 4.5% during 2020-23, driven by a weaker property sector, lower net exports and a maturing economy.
The structural shift in China’s economy is reflected in a lower investment weight and an increasing consumption weight in GDP (Exhibit 6). There has also been a sharp decline in loans to the real estate sector since December 2016, when the Chinese government’s policy of “houses are for living in, not speculation” began (Exhibit 7).
Exhibit 5: China’s gdp growth rate (%)
Source: FTSE Russell and LSEG. Annual data from December 31, 1999 to March 31, 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Exhibit 6: Composition of China’s GDP (%)
Source: National Bureau of Statistics of China, FTSE Russell and LSEG. Annual data from December 31, 2010 to March 31, 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Exhibit 7: China’s loan growth (cumulative, year-over-year %)
Source: National Bureau of Statistics of China, FTSE Russell and LSEG. Quarterly data from March 31, 2011 to December 29, 2023. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
The FTSE Emerging index is becoming more diversified…
While the sectors driving China’s GDP growth are evolving, faster economic growth and better equity market performance in other EM countries have led to a more diversified EM equity index. This can be seen in the shift of country weights in the FTSE Emerging index between March 2019 and March 2024 (exhibit 8).
India is now the second largest country constituent, up from third, and Saudi Arabia is now the fifth largest, up from a very modest share of the Emerging index five years ago. This reflects structural reforms that have provided tailwinds to their respective equity markets. (See our discussion of Saudi Arabia’s growth transformation here.)
Exhibit 8: Top 5 country weights in the FTSE Emerging Index (%)
Source: FTSE Russell and LSEG. Data as of March 31, 2019 and March 31, 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
…with healthy exposure to the Technology industry
Another important trend is that Technology as an industry has been a major driver of equity performance in recent years, with optimism around AI’s potential to bring about broad-based efficiency gains and to accrue benefits to technology sectors, such as chipmakers. It is worth noting that EM equities have substantial exposure to Technology, on par with DMs (Exhibit 9).
Exhibit 9: Industry weights in EM and major developed region indices (%)
| All-World | US | UK | Dev Europe ex UK | Japan | Dev Asia Pacific ex JP | Emerging | Developed | |
|---|---|---|---|---|---|---|---|---|
| Basic Materials | 3.4 | 1.7 | 7.4 | 4.4 | 5.2 | 11.1 | 6.3 | 3.1 |
| Consumer Discretionary | 13.8 | 14.0 | 11.6 | 13.7 | 23.2 | 8.9 | 11.8 | 14.0 |
| Consumer Staples | 5.4 | 4.6 | 14.9 | 7.5 | 5.7 | 3.4 | 5.7 | 5.4 |
| Energy | 4.7 | 4.0 | 12.3 | 3.7 | 0.8 | 3.3 | 6.7 | 4.4 |
| Financials | 14.5 | 10.7 | 18.0 | 18.4 | 12.3 | 27.2 | 23.0 | 13.7 |
| Health Care | 10.8 | 11.9 | 12.9 | 15.8 | 7.1 | 6.8 | 3.4 | 11.6 |
| Industrials | 13.2 | 12.0 | 15.7 | 18.5 | 24.9 | 10.9 | 8.3 | 13.8 |
| Real Estate | 2.3 | 2.3 | 1.4 | 1.0 | 3.5 | 6.8 | 2.2 | 2.3 |
| Technology | 26.2 | 34.3 | 0.9 | 10.6 | 12.0 | 6.4 | 24.7 | 26.4 |
| Telecoms | 2.8 | 2.1 | 1.1 | 2.7 | 3.9 | 12.5 | 3.9 | 2.7 |
| Utilities | 2.8 | 2.5 | 3.8 | 3.6 | 1.4 | 2.8 | 3.9 | 2.7 |
Source: FTSE Russell and LSEG. Data as of March 31, 2024. Indices shown here are the FTSE All-World, FTSE USA, FTSE UK, FTSE Developed Europe ex UK, FTSE Japan, FTSE Developed Asia Pacific ex Japan, FTSE Emerging and FTSE Developed. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
Investors attuned to structural EM changes
Investors may be becoming more attuned to these structural changes within EMs. After declining through 2023, the Emerging-to-Developed trailing P/E ratio has risen since January 2024, reflecting a narrowing of the EM valuation discount relative to DMs (the higher the Emerging-to-Developed P/E ratio, the lower the EM discount). Moreover, the current EM/DM valuation discount of 0.67 is far lower than in the early 2000s (the ratio was 0.35 at end-2001—Exhibit 10).
Exhibit 10: Equity Valuations in EMs relative to DMs (Trailing P/E, ratio)
Source: FTSE Russell and LSEG. Monthly data from January 31, 2000 to March 31, 2024. Past performance is no guarantee of future results. Please see the end for important legal disclosures.
In summary, EMs have changed and matured significantly since the Mexican Peso Crisis and the Asian Financial Crisis of the 1990s. EM GDP growth and earnings growth remain faster than those in developed markets. Within EMs, the growth model in China is evolving, while other EMs have started growing faster on the back of domestic structural reforms and changes in DM supply chains. The credit spread for EM sovereign bonds have fallen, while the realized volatility in EM equities is like that of DM equities. Investors are likely becoming more attuned to these shifts and pricing them into fixed income and equity markets, which may create tailwinds for EM returns.
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