Q2 2024 CIO Review and Outlook

Over the past quarter, emerging markets have performed largely in line with our expectations. The macro backdrop has generally been supportive. Inflation on the whole is not as high as in developed markets and balance sheets look healthy. And in the absence of rate cuts from the U.S. Federal Reserve, a lot of the positive performance in emerging markets has been driven by fundamentals and earnings growth.

The rapid growth and rollout of the supply chain of artificial intelligence (AI), led by large U.S. tech firms, has been another supportive theme for emerging markets. While a handful of high profile American firms—the so-called ‘Magnificent Seven’—remain in the investor spotlight, it is the companies in the tech hubs of Taiwan and South Korea that are providing the infrastructure and hardware that is key to enabling their services. It’s too early to say how AI will disrupt the consumer in Asia but right now demand for AI-related chips and server hardware is a real earnings and growth driver in the region.

The last quarter has also been characterized by market volatility triggered by surprise election results. Indian equities posted sharp declines when Prime Minister Modi’s party failed to get an overall majority and then rebounded when it became clear Modi had secured a coalition government with allies. In Mexico, Claudia Sheinbaum’s strong win was negatively received by markets concerned that it may herald an administration with a strong reformist agenda. The current political uncertainty in France is having ramifications for equities across the world. These political developments are a key reminder of the importance of incorporating a country dimension in the stock selection process.

Asian growth and value

Looking more closely at the performance of our markets in the last quarter, in Asia there has been a lot of differentiation. In Japan, the market was driven by outperformance among large cap stocks as they responded to regulator demands for improvements in capital efficiencies by selling down their cross holdings and buying back shares. Sector-wise, financials, energy and utilities were solid performers. We remain constructive on Japanese equities for the second half of the year for three reasons: resilient earnings growth supported by AI themes and semiconductors; capital efficiency gains; and, thirdly, positioning—global investors remain underweight to Japan which leaves valuations at a relatively reasonable level, in our view.

Taiwan was also a notable outperformer, buoyed by demand from U.S. tech firms for AI-related hardware and components. We think this growth runway remains very strong for Taiwan. In South Korea, we saw a lot of weakness in cyclical sectors. In certain areas including electric vehicles (EV) and EV battery making, oversupply is an issue and that has hurt prices and equity performance. Capital reform initiatives in South Korea are a welcome move but we don’t see them providing near-term support to the market. Finding value is still challenging in South Korea and we have become more selective.

“We see more upside to performance in emerging markets, driven by North Asia and underpinned by earnings and AI-related growth, with longer-term opportunities of optionality in markets that are more challenged, like Mexico and Brazil.”
Sean Taylor, Chief Investment Officer

In India, though Modi’s party fell short of an overall majority, we think India remains a very good structural story. The market’s initial reaction reflected worries that a new government less aligned with Modi would spend more on welfare and unwind some of the progress that the Indian central bank and government has made over the last few years. We don't think that's the case now given the coalition is formed of Modi’s allies. However, we do think spending on growth will broaden out beyond infrastructure and capex. Many in the coalition believe, we think, that the best way of dealing with poverty and increasing the rural spend is urbanization and so we think there will be better opportunities in consumption. But we have to be discerning. Some consumer stocks did very well after the election but they're often companies with low earnings and rich valuations.

Select opportunities in China

Turning to China, while it remains an economy with many challenges, it was a market that performed well in the quarter. We saw the government move to buy equities and stabilize the market and some policy changes, including key initiatives to try and get the property market back on its feet. Previously, the government addressed challenges in the real estate sector on the demand side but it’s the supply side where the problem is, in our view. Enabling provinces to buy real estate inventory from developers and use it for social housing should begin to take the stress off developers’ balance sheets and provide a meaningful tailwind.  

Macro indicators in China are still mixed: on the retail side there has been improvement but overall consumer sentiment is still quite weak and the property market remains disappointing. We are often asked what's the next phase in China’s recovery? In our view, there is unlikely to be a big stimulus, fiscal package, or a big devaluation of the currency as such moves in the past have left China with large debt burdens. That’s not to say there won’t be catalysts for growth. One catalyst may come from reforms or policy changes that could be announced at the Politburo’s third plenum gathering next month. 

For now, we are focused on companies that are producing better earnings. We have seen some improvements in China’s offshore markets, notably on the revenue side in larger sectors like digital and e-commerce. Margins are starting to widen and some companies are making narrower losses in some of their higher growth areas. We're also focused on having a balance in our portfolios. We have companies with good dividends and good dividend yield support with low valuations.

In terms of geopolitics, and particularly the upcoming U.S. presidential election and its ramifications for sentiment toward China, while a lot is priced into the markets there likely will be volatility as signals emerge over the potential winner and the types of policies that the new administration will roll out. So we think it is important to have a balanced portfolio in China. It could be that the election is an opportunity to reduce positions in China and add to other areas. Alternatively, as we near the election, valuations in China equities may decline and the market may overreact to the election outcome, in which case there could be an opportunity to increase exposure.

Latin America

Latin America and its interest rate-sensitive sectors has been harder hit by U.S. monetary policy. Looking at Brazil, rates are still over 10%. This challenge has been compounded by political volatility related to financial controls and the passing of budgets and that has led to a lack of confidence by international and local investors in the currency and the market. However, we think Brazil’s economy is generally in good shape; inflation is a little bit higher and stickier than anticipated but the underlying story is healthy. Brazilian companies are winning business and market share, they care about corporate governance and valuations are relatively cheap. Overall, we believe Brazil is a patience story. We expect that at some stage in the next six or nine months it will look very interesting relative to other areas in emerging markets.

Mexico has been seen as a very good structural story benefiting from U.S. growth and increasingly benefiting from overseas manufacturing investment, including from China. The election has caused some concerns that the government will pursue a mandate of societal and constitutional reform. We think it will take time for the market to understand the objectives of the government and so for the moment we believe the structural story in Mexico is on hold. We are also preparing for sentiment toward Mexico’s market to become more sensitive to geopolitical issues as the U.S. election nears. Whichever presidential candidate wins, we think it’s clear that U.S. policies toward China and trade will have an impact on Mexico’s economy and markets. 

Country selection as a risk control 

Taking a step back, we think post-COVID growth in emerging markets is starting to come through, beginning with technology and semiconductor segments in Asia, but also in ecommerce across regions, and growth is starting to broaden out. We think this trajectory will pave the way for consistent earnings growth in emerging markets over the next few years with Asia likely being the lead. A second driver will be monetary easing in the U.S. which should encourage Asian and emerging markets' central banks to cut rates. A cyclical pickup and strengthening economy in China would also support emerging markets economies but the scope and timing of this is unclear.

In summary, we see more upside to performance in emerging markets, driven by North Asia, underpinned by earnings, a broadening of AI-related adoption and growth, and by improving value in markets like South Korea. We also think India will continue to progress well, based on earnings prospects though valuations remain expensive. China will probably mark time, in our view. Catalysts would be welcome but their absence would not be a reason to reduce exposure to China. And then there are other opportunities of optionality with markets that have been more challenged, like Mexico, Brazil and ASEAN (Association of Southeast Asian Nations) countries. 

2024 is showing there are good growth opportunities in emerging markets. It’s a good year for active investors. When we make stock selections we understand the environment and we use country selection as a risk control for those opportunities. In this election-charged year, this approach is being fully utilized.

Sean Taylor
Chief Investment Officer