The Slow Divorce in Emerging Markets

December 5, 2023 | By: Regina Chi

The Slow Divorce in Emerging Markets

The bifurcation of equity returns was striking between some of the world’s developing nations in 2023. Here’s why an emphasis on strong fundamentals may hold the key to investing in EM’s changing landscape going forward.


Emerging Markets (EM) are poised to end 2023 with a bang, but not a relatively loud one. While the MSCI EM index has rallied in November, it is up 6% year to date, which is hardly terrible, but certainly not good when compared with the MSCI U.S. Broad Market (+14%) or MSCI World (+19%) indexes.

This should probably not surprise investors. A strong U.S. dollar and rising U.S. bond yields through the year hit EM currencies and limited the ability of central banks to cut rates. More recently, the geopolitical crisis in the Middle East sparked a modest flight to quality in global markets. And Chinese equities, which comprise nearly 30% of the MSCI EM index, have turned in a very disappointing year, down nearly 11% through November. Now, as the new year approaches, the question for investors is whether EMs can stage a sustained rebound – or whether their losing streak will resume.

There is some reason for optimism. Rate hikes from the U.S. Federal Reserve (Fed) may be at or near an end, with the prospect of cuts increasingly coming into focus for 2024, giving EMs room to cut rates themselves. A “soft landing” in developed economies, if it occurs, would give a cushion to EM economic performance going forward. Some Emerging Markets are in a better fiscal and current account position than they have been for a long time. And underlying a brighter outlook for 2024 is the potential for China to bounce back, something that has yet to occur in the post-pandemic period.

On the other hand, worse-case scenarios abound. Inflation and higher rates might buck current expectations and persist into next year. China might disappoint – again. Given these uncertainties, the counterbalance of opportunities and risks suggests that prudent EM investors may benefit from focusing on fundamentals and careful stock selection in 2024.

But first, let’s consider the “better-case” scenario, beginning with China. It is hard to overstate how much of a drag Chinese equities have been on overall emerging-market equity performance in 2023. China’s economy emerged from the COVID-19 lockdowns deeply scarred, and those scars have not yet fully healed. Post-pandemic, policy stimulus was initially much weaker and less effective than expected – our forecast for Chinese gross domestic product (GDP) growth in 2023 is just 4.7%, down a full percentage point from the start of the year. We believe China’s most difficult economic challenge remains over-reliance on fixed asset investment; it needs, as it has for several years now, to rebalance its economy towards consumption.

Despite those challenges, it’s possible that China is near the bottom of a cyclical slowdown rather than in the midst of a structural downturn. Manufacturing purchases, industrial production and retail sales picked up through the late summer and autumn, while consumer spending, which cratered in the middle of the year, has started to climb back. Macroeconomic policy has become more supportive, as China’s central bank has cut rates and reduced bank reserve requirements. Beijing has taken several steps to support domestic demand, including incentives for homebuyers and the potential development of sizeable urban housing tracts. Remarkably, China’s fiscal deficit shrank by 4.7% between mid-2022 and mid-2023 (compare and contrast to the U.S., which grew its deficit by nearly the same percentage); recently, however, the government appears to have changed course, and economists forecast a fiscal deficit of 3.5% for 2024. That could set the stage for an economic rebound and an uptick in Chinese equity performance. 

If Chinese stocks come back – at long last – then that may provide a significant tailwind for EM equities overall. Yet in some important ways, we believe China matters less to other Emerging Markets than it used to. One reason is simply that China’s recent slowdown is being driven largely by domestic, not global, factors, explaining the marked lack of “market spillover” from the troubled superpower. Meanwhile, developed economies have increasingly tried to de-risk from China by moving supply chains to friendlier shores, which has directly benefited emerging economies like Mexico and India.

The result: EM ex-China equities have fared just fine in 2023, up about 13% through November. And certain pockets have done far better than that. In fact, the bifurcation of results between China and ex-China are remarkable. Four of the five biggest constituents of the MSCI EM index – India, Taiwan, Korea and Brazil – are poised to finish 2023 in positive territory; China, of course, is the outlier. Other emerging countries more aligned with Europe than with China have performed extraordinarily well; The MSCI Poland and MSCI Hungary Indexes, for example, were up 37% and 41%, respectively, through November, boosted by falling inflation, interest rates and energy prices, as well as relatively cheap initial valuations.

What we may be seeing is a slow divorce between China’s growth prospects and stock markets and those of other EMs. Mexico, for example, is clearly benefiting from near-shoring. Its stock market and currency have been performing well in 2023, and it has replaced China as one of the top exporters to the U.S.

Investor interest in India, meanwhile, has been driven by its rising geopolitical influence, structural economic reforms and strong GDP growth (6.5% forecast in 2023); in some important ways, India’s future looks much like China’s past. Less well-known, perhaps, is the potential in Indonesia, the fourth-most populous country in the world, with a median age of just 30. That huge population remains under-banked (opening huge growth opportunities for banks and online payments firms) and under-connected (with e-commerce comprising only 4% of GDP, versus 11% in China).

Indonesia is also a leading supplier of nickel, a key component of electric vehicle batteries. Add the fact that domestic demand is strengthening, and Indonesia is positioned to turn in sustained 5%-plus annual GDP growth.

Put all of that together – the potential for a Chinese economic recovery and pockets of strength elsewhere – and the stage could be set for a sustained EM rebound in 2024. That depends, however, on a number of factors. One of them would be, of course, a rally in China, which may be close now that valuations are attractive, sentiment may have troughed and macro data is turning potentially more positive. Another requirement: a peak in U.S. yields and, relatedly, a relapse in the U.S. dollar. In 2023, Emerging Markets have performed largely according to script – when the greenback rises, EM falls – but if the Fed pauses and/or cuts in 2024, U.S. dollar depreciation and an EM rebound could follow. Finally, an easing of Mideast tensions would also clear some of the concern hanging over EMs.

In short, a few things have to go right for a widespread EM comeback in 2024. And quite a few things could go wrong. We believe one of the biggest downside risks to EM equities would be a structural shift higher in bond yields, which could occur should inflation once again prove stickier than expected. Higher borrowing costs will lead to weaker fiscal positions, which means EM governments will need to exercise more fiscal discipline (a negative for growth).

Another downside scenario is the economic slowdown in China proves persistent (though we do not subscribe to this). The Chinese economy still faces deep challenges in terms of debt, demographics and deflation. Its property market is weak – and 70% of China’s household wealth is tied up in real estate. The risk of a debt-deflation trap remains in China, and if it occurs it could jeopardize headline growth across EMs.

On balance we believe Emerging Markets will always present opportunities, however isolated, and a differentiated and disciplined approach that concentrates on strong fundamentals, a good structural story and sizable risk premia, at both the market and the equity-specific levels, will likely be key in 2024.

Regina Chi
Regina Chi, CFA®
VP & Portfolio Manager
AGF Investments Inc.
VP & Portfolio Manager

Regina Chi has lead responsibility for AGF’s Emerging Markets strategies. She looks for quality companies with fundamental catalysts and long-term sustainable competitive advantages at attractive valuations. Regina is a member of the AGF Asset Allocation Committee, a group of senior investment professionals that meet quarterly to discuss, analyze and assess the macroeconomic environment and capital markets to determine optimal asset allocations. She also serves as co-Chair of AGF’s Diversity, Equity and Inclusion Committee, which develops, creates organizational awareness around and promotes DEI best practices across the firm.

Regina brings more than 25 years of international equity experience to this role. Prior to joining AGF, Regina was a partner at a boutique U.S. investment firm, where she served as portfolio manager for the Emerging Markets and International Value disciplines. She was also head of portfolio management and research as they related to Emerging Markets, Global, International and International Small Cap strategies. Prior to this role, she held senior investment management roles at several large and boutique investment firms in the U.S.

Regina is a CFA® charterholder. She received her Bachelor of Arts in Economics and Philosophy from Columbia University. She is also a member of 100 Women in Finance, an organization working to strengthen the global finance industry by empowering women to achieve their professional potential at each career stage.

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