<img src="//beacon.etfflows.com/piwik.php?idsite=21" style="border:0; display: none;" alt="">

Emerging Market Equities – An Undervalued Opportunity?

The 24 countries in the Emerging Market Index represent 90% of the world’s population and 80% of the world’s GDP. So why is this market undervalued? More importantly, should you get invested?

Insights from Motley Fool Asset Management Originally posted on Friday, March 15, 2024 Last updated on April 17, 2024

read time 7 min read

Key Takeaways

  • Historically emerging markets have tended to outperform U.S. equities in the 12 months following a past Fed rate hike.
  • Emerging markets equities historically have typically shown gains during periods of a weakening U.S. dollar.
  • Other factors that we believe might support emerging markets outperformance include reshoring, green investments, and technology and innovation.

Many investors are underweight or not invested at all in emerging markets (EM) equities.1 This is understandable given the underperformance of the emerging markets equities over the past 15 years compared to the U.S. markets, as well as many non-U.S. developed markets. Despite recent underperformance, we believe there are reasons to think EMs might offer opportunities for investors moving forward. 

These reasons include: improving business climates in many of the countries comprising the emerging market, trends that include bringing more manufacturing into some of these countries, developments in technology, and a movement towards green investments that favor commodity production in some of the countries. Add in a potentially weaker dollar and the gains emerging markets equities have historically enjoyed following past Fed rate hikes, and we feel it’s an idea worth digging into.

What are emerging markets?

The widely followed MSCI Emerging Markets Index includes 24 countries. China (24.87%), India (17.98%), Taiwan (16.61%) and South Korea (12.24%) together comprise almost 72% of the index on a market-cap-weighted basis.2 

These countries represent some 90% of the world’s population and about 80% of the world’s GDP.1 However, the stocks of companies headquartered in these countries account for less than 15% of the total global stock market cap.

Between 2009 and 2023, emerging markets equities cumulatively returned less than half of what U.S. large cap equities have (6.8% versus 14.0%), though there were some solid individual years for EM equities within this time period.3 However, prior to that, from 2000 through 2010, EM stocks vastly outperformed U.S. stocks, gaining an annualized 18.5% over this time period, compared to 4.1% for U.S. stocks and 5.3% for ex-U.S. developed markets.4 

So, what might make investors think things going forward could look more like 2000 through 2010, a period marked by crises such as 9/11, the bursting of the housing bubble, and the Great Recession?

Emerging markets and Fed rate hikes 

Historically, emerging markets have tended to outperform U.S. equities in the 12 months following a Fed rate hike.4 For example, in the prior three rate hike environments, with 12 month periods ending in 2000, 2005, and 2016, the MSCI Emerging Markets index outperformed the S&P 500 by 10 percentage points on average.1

In the past, EM cycles of outperformance tended to run for several years at a time. The most recent Fed rate hike occurred in July 2023,5 so we believe now could be a potential opportunity for investors, at least for the first half of 2024, though this could run longer.4

The U.S. Dollar 

Emerging markets equities have typically shown gains during periods of a weakening U.S. Dollar historically. In the past, the price of EM equities increased as much as 4% for every 1% of downward movement on the value of the USD.1 We believe part of that relationship stemmed from the inverse relationship between the USD and the price of many commodities; many countries designated as EM supply commodities to developed nations.

In addition, we feel another reason a weaker USD could potentially help boost the bottom line of emerging markets arises from the fact that many of these companies have funded their growth with USD-denominated debt. An argument could be made that a lower valuation for the USD could reduce the cost of this debt in local currencies, potentially boosting the bottom line of these companies. 

Will the U.S. Dollar weaken? We can’t know, but there are factors to keep an eye on.

  • Interest rates — and whether the Fed follows through with their plan to cut them. Lower rates tend to attract less capital to the U.S., which in turn can lead to lower demand for the dollar and weakness in the currency.
  • Election uncertainty in the United States. Both major candidates have shown a preference towards increased spending, which could lead to a larger budget deficit. A larger budget deficit could help decrease the value of the USD relative to other currencies.
  • The prospect of government shutdowns has become more pronounced in the U.S., eroding confidence in the value of the USD.

Other factors to consider 

There are several other factors affecting emerging markets countries that we believe could potentially support outperformance.4 

Reshoring, or expanding their role in manufacturing (and ultimately in the supply chain) is a trend among several EM countries. Mexico is growing their market share in vehicle assembly, especially in the EV sector, which, in addition to its proximity to the U.S., has allowed it to overtake China as a manufacturing source for many U.S. companies in recent years.4 Reshoring can potentially have a significant impact on the economies of the countries involved, which could thereby create a positive operating environment for the companies already operating in these counties, and possibly for the creation of new businesses. 

Green investments, such as investing in EVs, solar power, smart power grids, and other green technologies, require the use of commodities such as copper, nickel, cobalt, and lithium. Several of the major suppliers of these and other commodities are based in EM countries such as China, Argentina, Chile, Indonesia, and others. Companies producing and supplying these commodities might enjoy a surge in profitability — both from increased demand and favorable pricing — due to the projected decline in the USD. Many countries, including the U.S., China, and India, have green agendas.

Technology and innovation are key drivers of growth in many EM countries. China, for example, is a leader in digital payments; across Asia, digital wallets account for about three times the retail payments made compared to Europe.4 

Is 2024 the year for Emerging Markets leadership? 

You might be leery of any positive predictions for EM equities, given how deeply these stocks have disappointed investors over the past decade and beyond. It’s understandable.

And there are certainly reasons to approach investing in this sector with care. Beyond the 2024 presidential election here in the United States, there are a number of elections — India, Mexico, and South Africa, to name a few — that could have implications for the economic climate of EMs.

There is also political risk, including ongoing issues between the U.S. and China that could affect both the U.S. economy and those of EMs.

But we feel that the current undervaluation of EMs as a whole, plus the economic trends we’re seeing in those markets, may be catalysts for these equities to finally break out of their prolonged slump. It could provide valuable diversification for U.S. investors, who are typically overweight in U.S. stocks.6 

Just because a market segment is undervalued doesn’t necessarily mean that it is ripe for recovery — or that it would be a valuable component of everyone’s portfolio. If you’re considering EM equities, be sure to do your due diligence and balance out the risk profile with other investments. 

How to invest with us

Click the button below to learn how you can get started with Motley Fool Asset Management

Motley Fool Asset Management