Emerging Markets: The unanswered paradox of attractiveness and growth

On Nov 23, 2024, the Wall Street Journal published an article which deplored the systemic underperformance of Emerging Market (EM) stocks over the past few years, arguing that the time is ripe to selectively invest in countries with higher upsides in the near-term future.[1] It is true that EMs have had a sloppy showing in the last 2 years, especially compared to the U.S equity market.

Fig 1. MSCI US-only index crushes the MSCI Emerging Markets index by leaps and bounds in the past 2 years. Source: LSEG Workspace

A large part of this can be attributed to the strong dollar, which, despite recent rate cuts in September, has been buoyed by persistent inertia from the Fed for over 4 years and bumped up by potential appreciation pressures over the Trump trade. A robust dollar erodes EM equity returns as local currencies depreciate, resulting in less real returns in USD. Additionally, a strong dollar signals higher returns on USD-denominated assets, attracting foreign capital and diverting it away from emerging markets.

Fig 2. USD, the bane of emerging markets. Source: LSEG Workspace

However, this has not always been the case. Excluding 2022-2024, long-term horizons of 10 or 20 years favor EMs, which have yielded greater returns than US-Cap stocks.

Fig 3. Surprise, surprise. Emerging Markets have handily beat US equities for a 20-year period fom 2002-2022, before losing out in 2023 with interest-rate hikes and a strengthening dollar. Source: LSEG Workspace

Fig 4. By comparing the MSCI Emerging Markets index with the MSCI EAFE (Developed Markets excepts North America), we see that the former crushes the latter over a 20-year time horizon. Source: LSEG Workspace

This is even more evident when comparing EMs to Developed Markets (Excluding US and Canada) over the same period. Anemic GDP growth rates in Europe and the small economic scale of developed Asian economies have had underwhelming performances compared to the robust gains seen in emerging markets.

This set of counter-intuitive results therefore explains the puzzling statistic published by the IMF: Despite 20-year high U.S interest rates and a tight macro-economic environment, capital inflows to EMs have rebounded sharpy to $110 billion, the highest since 2018.[2] While investor sentiment is best classified as “cautiously bullish” by a HSBC survey conducted June-September 2024, [3] the principal reasons for downside risks have already been eliminated. Recession risk in major economies (even Germany, which is expected to grow 0.7% in 2025) has been dialed down, while rate cuts have been projected, albeit mitigated amidst inflationary pressures.[4] [5] More importantly, economic growth in EMs, while subject to notable headwinds such as protectionist measures, seems to be fundamentally girded in long-term economic advantages which they benefit from: Increasing marginal returns per capita invested due to an under-resourced capital base, large demographic surpluses, and increasing global demand with decreasing inflationary pressures.[6] These were the underlying factors which influenced systemically strong returns in the EM markets in the past 20 years. Even USD strength, a key determinant of EM performance, becomes less instrumental once we lengthen the time-horizon.

Fig 5. Correlation b/w USD and Emerging Market returns is not as one-dimensional as conventional wisdom suggests. Source: LSEG Workspace

Correlations clearly exist between the two variables, but the rise in EMs over 20 years (+228.98%) overshadows temporary adjustments from US dollar fluctuations. This is explained by the fundamental growth drivers mentioned above. More recently, EMs have been particularly active in increasing foreign investment and domestic participation. The China stimulus in September allowed for close to 800 billion RMB in equity financing through a combination of asset swaps and loan issuance. India has also pursued policies of IPO streamlining (2024), allowing for greater liquidity in domestic markets, while the gradual opening-up of the Saudi Stock Exchange (10th largest in the world) has also allowed for greater market visibility and ease of investment. These measures are crucial in allowing public market investors to capitalize on the economic growth in these developing economies, which allows for the most direct access to greater equity returns.

Oftentimes, narratives of economic sovereignty or the widespread utilization of other assets (real estate or precious metals) hamper the development of national bourses as a financial instrument for wealth accumulation. For example, over 60% of Americans own stocks, compared to just 16% of Chinese individuals.[7] [8] Additionally, while large institutions hold a significant portion of the U.S. stock market, the Chinese market is primarily dominated by retail investors, creating greater betas and therefore lower sharpe ratios.[9] If China were to accord greater importance to its equity markets, the lowest hanging fruit to achieve increased returns would be plucked, since removing capital restrictions would be an endogenous measure that is an administrative hassle, and not a technological challenge. However, there are two sides to a coin. Continued barriers on stock exchanges in EMs provide financial stability and national sovereignty, a trade-off that these countries are willing to make for greater potential growth. While we cannot expect complete liberalization of financial markets to happen, it is likely that financial liberalization remains the most attractive method for strong economic performance, especially for existing companies that might need more capital for dynamic growth.[10]

References

[1] McLain, S. (2024, December 28). Emerging markets stocks have rarely been so hated. It's time to buy. The Wall Street Journal.

[2] International Monetary Fund. (2024, July 12). Emerging markets show resilience despite global monetary tightening. IMF Blogs.

[3] Ulgen, M. (2024, September 25). Conditional love: A survey of emerging markets. HSBC Global Research.

[4] Organisation for Economic Co-operation and Development. (2024, December). Economic outlook: Global growth to remain resilient in 2025 and 2026 despite significant risks. OECD News.

[5] Ulgen, M. (2024, September 25). Conditional love: A survey of emerging markets. HSBC Global Research.

[6] International Monetary Fund. (2024). World Economic Outlook. IMF Publications.

[7] Wei, L. (2024, December 27). Small investors are a big problem in China. The Wall Street Journal.

[8] Gallup. (2019, December 30). Percentage of Americans who own stock. Gallup News. Retrieved

[9] UBS Asset Management. (2021, January 14). China equities: The alpha opportunity. UBS Asset Management.

[10] Gupta, N., & Yuan, K. (2009, November). On the growth effect of stock market liberalizations. The Review of Financial Studies, 22(11), 4715–4752.