Revisiting emerging markets: catalysts & opportunities ahead

• While emerging market returns have underwhelmed over the last decade, both near- and long-term catalysts suggest revisiting the asset class.
• In the near term, we believe the macro-economic environment could turn favorable to emerging markets as expected rate cuts in the U.S. would likely weaken the U.S. dollar.
• Over the long term, powerful mega forces like youthful demographics and rewiring supply chains could favor certain emerging markets countries like India and Mexico.
• While many advisor portfolios are underweight emerging markets, the current macro environment appears to offer many opportunities across EM. Advisors may want to consider more granular exposures within emerging markets to target the most compelling opportunities.

Emerging markets (EM) have disappointed over the past decade, as a generally strong dollar, weak commodity prices, and low corporate earnings growth led to underwhelming returns relative to developed international stocks and U.S. large caps.¹ However, macro tailwinds such as likely Fed rate cuts, reshoring, and rising commodity prices suggest we could see a reversal in EM fortunes in the near term.

Expected interest rate cuts by the Federal Reserve could weaken the U.S. dollar, as yields would potentially become less attractive, increasing the value of overseas assets, and reducing the burden of dollar-denominated debt issued by emerging markets. Historically, emerging markets have performed better as the U.S. dollar has weakened, as illustrated in the chart below:

Looking beyond rates, commodities create a pocket of potential opportunity for emerging markets as well. Commodity prices remain elevated at nearly 25% above their 10-year average, driving more revenue to commodity exporters². This can be a positive for emerging markets which typically have larger exposure to energy and materials vs developed markets such as the U.S.³

Over the longer term, powerful mega forces, like shifting demographics and rewiring global supply chains, suggest emerging markets could be well-positioned. Investors may want to consider more granular exposure within emerging markets to target the most compelling opportunities.

Demographic divergence is a mega force that can’t be ignored, as a growing economic wedge is forming between two groups: ageing countries and youthful populations.

Many developed countries are ageing rapidly, as lifespans extend, and birth rates decline. In the U.S., 2024 is expected to be the first year there are more people over the age of 65 than under the age of 15⁴. And the U.S. is not alone, with economies across Developed Europe and parts of Asia rapidly ageing. Ageing populations can both shrink workforces as there are less citizens of working age and tax government budgets with greater age-based health care needs. The ripple effects of these challenges could lead to slower global growth, persistent inflation, and overstretched government deficits.

But in certain emerging markets, the script is flipped. Looking beyond China, which itself is ageing, countries like Mexico and India enjoy relatively youthful populations and growing workforces as illustrated below. In emerging market countries where the working-age population is growing quickly, there are potential tailwinds for greater economic output, growing consumption, and an increase in foreign investment given these opportunities that aren’t present in developed markets. Coupling these tailwinds with commensurate investments in infrastructure and participation in global trade could make these youthful countries global growth engines over the next decade. (Learn more about India, the world’s fastest-growing major economy.)

As a consequence of the COVID-19 pandemic and rising geopolitical tensions, supply chains have been rewiring, accelerated by new trade deals, domestic policies, and a focus on supply chain resilience. In our view, such rewiring could create new winners and losers, particularly within emerging markets who may have higher exposure to manufacturing and materials.

One region that could benefit is Southeast Asia, where countries like Indonesia and Malaysia have become more globally competitive due to their lower cost of labor and participation in multiple trade deals like the Indo-Pacific Economic Framework (IPEF) and Regional Comprehensive Economic Partnership (RCEP).^{5 6}

Mexico has been a beneficiary of “near-shoring”⁷ where production moves closer to the final consumer, as well as U.S. policies like the Inflation Reduction Act to stimulate more North American production in key industries. Mexico remains the United States’ top total trade partner, accounting for over 16% of total trade⁸. Much of this trade has been driven by the auto industry; from 2018-2022 Mexico increased total U.S. imports by $58 billion, with $12 billion of that growth driven by exports of auto components.⁹

Many investors remain underweight emerging markets, with the average advisor portfolio holding 4.6% EM exposure in their equity sleeve¹⁰. To put that allocation into perspective, the MSCI ACWI index has nearly 2% more EM exposure at 6.7%¹¹. Not only is there an opportunity to increase exposure to emerging markets, but to increase strategic allocations and to get more precise in exposures to potential tailwinds. BlackRock Target Allocation model portfolios, for instance, currently seek to maintain a strategic tilt towards countries with potentially more attractive earnings and long-term economic growth prospects, such as India and Taiwan¹².

When pursuing opportunities in emerging markets in the coming years, a more granular approach can be considered that targets the most compelling countries. One way to get more granular with emerging market exposure is to separate China from the broader emerging market benchmark, like Japan was broken out from the broader APAC region in the early 2000s, the size and idiosyncrasies in China could warrant its own allocation in portfolios. China represents a quarter of the MSCI Emerging Markets Index by weight, and yet, has contributed to over half of the country risk of the index, which is the risk associated with investing within a certain country¹³. Additionally, by breaking out China, the ex-China index has an increased weighting to what we believe are some of the most compelling emerging market opportunities, such as India’s increased weight from 18% to 25%, Southeast Asia from 4% to 6% and Mexico from 3% to 4%¹⁴.

The current macro environment appears to offer many opportunities across emerging markets. Taking a modular approach whether through ETFs that limit certain exposures, or single country ETFs, will allow investors to target the countries that look well poised for growth.