A weaker US dollar and signs of a potential recovery for China are making emerging market equities a more attractive proposition for investors. Fidelity Emerging Markets Limited (LON:FEML) portfolio managers Nick Price and Chris Tennant assess the backdrop and uncover the key areas in which they are finding opportunities.
Emerging markets have been out of favour for many years, with capital flowing into the US. However, we think that emerging markets now present a compelling case. Despite a tough backdrop in China, there are positive signs of property price stabilisation and government stimulus. Meanwhile, countries like Indonesia and Mexico offer attractive valuations, while a weaker US dollar further strengthens the prospects for emerging markets.
A challenging but improving backdrop for China
The backdrop for the Chinese consumer has been tough, and consumption as a proportion of GDP remains very low versus developed markets. This is down to an elevated savings rate and the fact that the ratio of house prices to incomes remains elevated even with the decline in property prices.
While the high relative cost of housing means there will likely continue to be a period of adjustment, overall, it seems we are through the nadir of property price declines, with signs of stabilisation in tier one cities, if not outright recovery. While the government does not want to drive another bubble in construction volumes, policy measures are aimed at putting a floor in prices. A mix of lower interest rates and stabilising but structurally lower house prices point to a better backdrop for the Chinese consumer.
Other parts of the market are tough. The savings rate is high, but there are limited places to put this money to work, pushing up high-yielding stocks like banks, which are structurally challenged. Rate cuts are negative for net interest margins, and there is a divergence between the rise in reported corporate losses and bank provisioning, which is the lowest in a decade. Heavy industrials are also challenged given excess capacity in many industries.
China will likely manage its way through higher tariffs, given there is often little alternative to Chinese products at the price point available. There is a question over whether we will see a revaluation of the renminbi, with the current dollar peg increasingly out of sync with the rest of the world.
We are most positive on the consumer space, where many stocks are cheap, returning capital to shareholders, and should benefit from consumer deleveraging and government stimulus. However, reporting quality remains poor, and government intervention persists. There are pockets of opportunity, though, as consumers shift from international to domestic brands, and in underpenetrated ‘experiences’ categories like music streaming or travel.
Finding opportunities across emerging markets
We are constructive on Indonesia, which has excellent demographics but trades at a fraction of the multiple of countries with similar tailwinds. We particularly like noodle maker Indofood, which benefits from a great domestic market structure, and has presence in the underpenetrated Middle East market. Indofood trades at ~6x earnings, around a tenth of the multiple of peers in India.
The de-rating in Mexico has created opportunities to buy cheap, high-quality compounders, for example tortilla maker Gruma. Two-thirds of Gruma’s profits come from the US and it would trade at a significant premium to its current multiple were it listed in that market, while localised production bases also protect it from any potential increase in tariffs.
Electrification is another area of focus. The shift in the generation mix requires a reengineering of the grid, which along with electric vehicles, is the largest demand driver for copper. We hold several copper miners, for example Peru’s Buenaventura. We also have direct exposure to the theme through Sieyuan Electric, a Chinese electrical equipment maker that is the only private company competing with a group of inefficient state-owned enterprises.
One mid-cap company we are particularly excited about is Georgia’s TBC Bank. Georgia has a population of just under 4 million people and TBC is one of two dominant banks in the country, which together have about 80% market share. TBC Bank earns returns on equity of more than 25% but trades on only ~5x earnings, a very cheap multiple for such a dominant, profitable bank. It has just launched a digital bank in Uzbekistan, a market with a population 10 times the size of Georgia’s, offering huge scope for expansion. With an experienced CEO that has an excellent track record of running fintech companies, this expansion into Uzbekistan offers great optionality.
The outlook for emerging markets
The fiscal backdrop and state of sovereign balance sheets is one of the defining issues of today. The US has an elevated fiscal deficit that has little chance of being reined in, and for the first time, people are questioning the sustainability of its debt.
Against this backdrop, the relative fiscal position of emerging markets looks very strong. There are some exceptions to this, Brazil being a notable outlier, but broadly we have seen much more fiscal constraint among emerging markets during this cycle. While the US drew on the fiscal toolbox during Covid, we saw the opposite in most emerging markets, particularly China, which tightened policy to deflate the property bubble.
Today we are starting to see this dynamic shift, as the fiscal backdrop and policy unpredictability weigh on appetite for US assets, while China has shifted to reflating the economy, having achieved what it set out to do in the property sector. Much of the weak sentiment towards emerging markets in recent years has been driven by the drawdown in its largest constituent, China, and it now appears that much of what drove the derating of emerging markets is reversing.
Today’s world of fiscal largesse is also resulting in a weaker US dollar. If that continues to persist, it’s a very good backdrop for emerging markets, supporting local currencies and resulting in less imported inflation, with more money in the pockets of consumers. A weaker dollar is also supportive for commodity-exporting economies like Brazil and South Africa.
The valuation backdrop is decent for many, if not all, emerging markets, with countries like Mexico and Indonesia trading at very low multiples, and China, despite the rerating, also looking cheap overall. Taiwan remains relatively expensive, but some of this premium is warranted given its position as home to the AI supply chain.
Emerging markets as an asset class is far from perfect, with continued risks around populism, geopolitics and trade tensions, although these are also issues that we face in the developed world. But with the tailwind of a weaker dollar, a relatively robust fiscal position, and signs of recovery of China, we think that emerging markets look well positioned today and it is certainly an asset class that deserves scrutiny at this point in time.
Important information
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Fidelity Emerging Markets Limited (LON:FEML) is an investment trust that aims to achieve long-term capital growth from an actively managed portfolio made up primarily of securities and financial instruments providing exposure to emerging markets companies, both listed and unlisted.
