Are emerging markets the next great stock market play?

The stock market’s blink-and-you-missed-it correction this spring is a clear indication that shares remain on an upward trajectory. These rapid-fire round trips happen when investors are busy looking for reasons to buy not sell, to see the glass as half full. The S&P 500 lost 5.4% in three weeks between the end of March and the middle of April. But within a month it had recovered all of that and more.

Another indication that the bulls are in charge for now is the breadth of the recovery. Investors sense that lower interest rates are imminent and have started to look beyond the market leaders. The equal-weighted version of the US benchmark has finally moved beyond its 2021 peak, with 80% of companies trading above their 200-day moving average, a key measure of momentum. Smaller companies, too, have broken upwards out of their three-year sideways drift.

Crucially, the prospect of the Fed joining its counterparts across the Atlantic in a co-ordinated easing of monetary policy has seen the dollar give up its recent strength. It had gained around 5% by the middle of April against a basket of other currencies, and it is now on track for its first down month of 2024. That has lit a fire under risk assets like commodities and emerging market equities, the investments that have borne the brunt of the US central bank’s restrictive approach.

Commodities are priced in dollars, so a weakening of the US currency makes them cheaper to buyers elsewhere in the world and boosts their price, all other things being equal. The copper price was $8,000 a tonne in February, and it is nearly $11,000 today. Gold has risen by 20% over the same period and silver by even more.

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Stock markets in the developing world also like a weak dollar, because, among other things, it reduces the burden of any borrowings that are denominated in the US currency. Emerging market shares have risen by more than a fifth in the past six months, despite the main contributor to that performance, China, rising by only 5% since October.

Stripping China out of the MSCI Emerging Market index paints a much more encouraging picture. On this basis, shares in the rest of the developing world have recouped all of the losses incurred since the 2021 post-pandemic peak. It is early days, however. Over the past 10 years, emerging market shares have gone sideways while the US stock market has nearly trebled. What are the chances of the next decade seeing a reversal of that trend?

There are many strands to the case for emerging markets - some short term, others a slower burn. Crucially both are now pointing in the same direction.

The tactical reasons to favour emerging markets today include the growing likelihood of a soft landing for the global economy. The return of inflation towards many central banks’ 2% target makes interest rate policy look too restrictive. The cost of borrowing will fall from here. At the same time, economic growth and corporate earnings are strong enough. Not too hot and not too cold is the Goldilocks scenario. Crucially, though, GDP growth in emerging markets, at nearly 5%, is more than three times that of the developed world.

The economic fundamentals in emerging markets are also much better than they were 10 years ago. Current account balances have improved, there is less dollar-denominated debt and greater foreign exchange reserves. Developing countries are much better insulated against future shocks. Having moved quickly to raise interest rates, they also got on top of inflation ahead of the developed world and in some cases are already cutting the cost of borrowing.

Other short-term advantages include the exposure of many emerging markets to the nascent commodities boom. The ongoing shift towards a net zero world has highlighted the gap between growing demand and inadequate supply for many natural resources, including metals like copper and nickel that are key components in the build-out of clean energy and electric vehicle infrastructure. Another under-appreciated advantage is the developing world’s exposure to artificial intelligence via its dominance in semiconductor production.

All of these tactical advantages build on the long-term structural case for emerging markets. This includes their demographic edge, with 90% of the world’s working age population and two-thirds of its high-consuming middle class expected to be living in emerging markets within a few years. The developing world accounts for 80% of economic growth, nearly 60% of GDP but only 11% of the value of global stock markets.

Part of this is due to the lower valuations attached to emerging market shares. They trade on a multiple of earnings in the low teens compared to nearly 20 for developed markets and even more in the US. This despite expected profits growth being significantly higher - 19% versus 11% this year, according to Lazard. You would expect riskier emerging markets to trade at a discount to their safer developed market peers, but the gap is wider than it should be.

There are different ways of playing emerging markets, an extremely diverse investment set. My preference is to put my eggs in several baskets. India is on a roll, with booming services exports (up 150% since 2019) accompanied by a growing manufacturing sector as companies like Apple look to diversify their supply chains. But it is expensive, trading on a par with the US market, with high valuations most obvious in hot areas like consumer stocks.

China, on the other hand, is out of favour, with a long list of headwinds, from a potential Trump Presidency to a fragile property market which still accounts for a worrying proportion of Chinese savings. The price you are being asked to pay, as an investor, is commensurately low, however. Valuations remain extremely depressed despite a nearly 20% rebound since February.

There is a strong case for maintaining a permanent exposure to emerging markets to share in their long-term growth advantage. Today, I’d argue that the stars are aligned for short-term tactical outperformance too.

This article was originally published in The Telegraph.

6 ways to invest in Asia and emerging markets

Our Select 50 includes a list of our favourite funds, selected by experts. Currently, the list features 6 funds that offer exposure to Asia and emerging markets.

1. Comgest Growth Emerging Markets

This fund invests in a portfolio of high-quality, long-term growth companies. Among its top 10 holdings, investors can gain exposure to countries like Taiwan, Mexico, India, and China. There are some familiar companies too, including semiconductor producer, TSMC and India’s HDFC Bank.

Our experts like this fund because it is a fairly concentrated fund that invests in companies across emerging markets. Comgest are also skilled at finding companies with high quality characteristics. The fund’s ongoing charge is 1.1%.

2. Fidelity Funds Asia Smaller Companies

The fund’s portfolio manager uses a bottom-up security approach within the Asia Pacific, ex Japan smaller companies’ universe. Currently, half of the fund’s top 10 holdings offers exposure to India. Indonesia, China, and Taiwan also make it in the fund’s top holdings.

Our experts like this fund because it looks for future winners from a region (Asia) that is an important driver of global growth. The fund’s ongoing charge is 1.09%.

3. iShares Core MSCI EM ETF

This is a passively managed fund that tracks an index made up of large, mid, and small companies from emerging markets. Its top 10 holdings including TSMC, China’s Tencent Holdings and South Korea’s Samsung Electronics.

Our experts like this fund because BlackRock, which runs iShares has good experience in index tracking and the fund is well priced. The fund’s ongoing charge is 0.18%.

4. Lazard Emerging Markets

 This fund aims to outperform the MSCI Emerging Markets Index, opting for companies with over $300 million in market cap and with sufficient liquidity. There’s a blend of both cyclical and sensitive stocks, in countries like Brazil, Portugal, Hong Kong and Hungary.

Our experts like this fund because the fund’s manager are value investors, that buy companies with depressed share prices. They also have a history of investing in this style for many decades. The fund’s ongoing charge is 1.09%.

5. Schroder Oriental Income

This fund aims to provide a total return for investors via investments in companies which are based in, or which derive a significant portion of their revenues from the Asia Pacific region, and which offer attractive yields. There is also some exposure to Australia and Singapore.

Our experts like the fact this is an investment trust, as it has more freedom to invest compared to an open-ended fund. There’s also a focus on companies that pay higher quality dividends. The fund’s ongoing charge with performance fee, estimated is 0.87%.

6. Stewart Investors Asia Pacific Leaders Sustainability

This fund invests in shares of large and mid-sized companies which generally have a stock market value of at least $1 billion. There’s also a focus on high quality companies that are positioned to contribute to and benefit from sustainable development.

Our experts like this fund because the manager has a long tradition of investing in the region and benefits from an experienced team of experts. The fund’s ongoing charge is 0.84%.

Important information - investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Investments in emerging markets can be more volatile than other more developed markets. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. Select 50 is not a personal recommendation to buy funds. Equally, if a fund you own is not on the Select 50, we're not recommending you sell it. You must ensure that any fund you choose to invest in is suitable for your own personal circumstances. Please be aware that past performance is not a reliable guide indicator of future returns. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to one of Fidelity’s advisers or an authorised financial adviser of your choice.