For more than a decade, US stocks have essentially been the only game in town for equity investors. Emerging markets (EM) such as China, India, and Mexico have been left behind, as the dominance of the ‘FAANG’ stocks (an acronym for Facebook, Apple, Amazon, Netflix, and Google) powered US markets higher. More recently a new group dubbed the ‘Magnificent Seven’, consisting of most of the FAANG stocks but with the addition of Microsoft and high-fliers Nvidia and Tesla, have tilted the balance further in the favour of US equities.
Aided by the launch of GPT-4 on 14 March 2023, the market capitalisation of the ‘Magnificent Seven’ now represents an impressive 81% of the collective capitalisation of EM stock markets. The ‘Magnificent Seven’ are large corporates even by US standards, equivalent to nearly 40% of the capitalisation of the remaining 493 stocks in the S&P 500.
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Since the stock market bottomed after the Global Financial Crisis (GFC) in March 2009, US stocks have returned an impressive 17% annually, well above the 30-year average of about 10% between 1993-2023. Over the same period, EM stocks have returned about 7% annually; cumulatively since March 2009 EM stock performance has trailed the US by almost 60%. The liquidity carpet laid down by loose US fiscal and monetary policy after the GFC shock went a lot further than just stabilising the markets: it helped to propel corporate America to heights of equity performance which other countries, and especially EMs, have struggled to match.
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The start of 2024 seemed to herald yet another year when EM stocks would lose ground. EM equity markets (as measured by the MSCI Emerging Markets index) fell 4.7%, the largest underperformance for the month of January since 1998. Market sentiment weakened, as investors perceived the strength of the US economy as a sign that the Federal Reserve would keep interest rates higher for longer.
Since then however there has been a turnaround in the fortunes of EM stocks. Performance in February and March improved so much that the three-quarter return momentum for the EM global index was up by almost 2%. One driver of that improved performance was energy, as geopolitical tensions boosted EM energy exporters such as Brazil and Saudi Arabia. In addition, stronger macro fundamentals coupled with AI-related optimism lifted technology-heavy EM markets such as Taiwan and South Korea.
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EMs typically have higher expected GDP growth than developed economies; this reflects the process of ‘catch up’ to the technology frontier, as they adopt proven technologies previously developed by pioneers in the US and other advanced economies, coupled with the advantages of a young and growing population to sustain production. Lately, it appears, this growth expectation has been viewed more favourably by financial market participants. Future earnings are now expected to grow faster in EMs than in developed markets, a fact reflected in the higher 12-month forward Price-to-Earnings (P/E) of EM stocks relative to DMs.
This positive differential between the P/E ratios of EMs and developed markets is a notably rare event — it has only happened around 2% of the time in the past 80 quarters (20 years). Normally the expectations of higher growth are cancelled out by wariness of higher levels of currency volatility and other risks.
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There could be a number of explanations for the current outperformance of EM markets, depending on the circumstances of individual countries. Equity markets that are performing well could be manifestations of countries that are seen to be transitioning successfully from emerging market to more developed status. In addition, when China endures a period of underperformance, other emerging economies appear unaffected and continue to perform well. India, in particular, is attracting foreign direct investment due its huge economic potential. Fathom has previously written in this blog of India’s recent outperformance and its ability to seize its opportunities.
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Emerging markets started to gain more attention during COVID-19 because of the distribution challenges and the reshuffling of supply networks amidst the lockdowns. Some of these changes turned out to be more persistent than many thought due to geopolitical shifts.
Mexico is an EM that stands to benefit notably from the de-risking of global supply chains away from China. Supply constraints in Western economies during the pandemic highlighted the risks of concentrating production in the Far East, mainly in China. US/China tensions have also accelerated a shift toward bringing production closer to home or relocating it to more congenial countries. Mexico is well positioned for the ‘nearshoring’ of production bound for the US.
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Fathom is monitoring the interplay of geopolitics with EM countries and plans further research on this topic, which it will share with LSEG readers in due course.
The views expressed in this article are the views of the author, not necessarily those of LSEG.
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