In recent memory, emerging markets have been somewhat absent from the equity market party. The benchmark equity index, MSCI Emerging Markets (MSCI EM), still sits some 15% below its 2007 peak. On the surface this makes sense, as investors in emerging markets must contend with a plethora of challenges. While not all can be tarred with the same brush, many emerging economies face political conflict, natural disasters and a lack of property rights, autocracy, cronyism and corruption. Their markets can be less liquid, with an abundance of currency volatility and poor corporate governance. Understandably then, there is enough to make investors look elsewhere for better risk-adjusted returns. Here, we take the opportunity to discuss why we are willing to look past these challenges to access some of the most attractive growth opportunities worldwide and furthermore, why we believe emerging markets are set for a revival thanks to the structural changes taking place in the global economy.

Emerging markets come in many different shapes and sizes, but in their aggregate, they account for 60% of global GDP and 75% of the global growth experienced over the past 25 years. Yet for all this prosperity, they only make up around 10% of global equity market capitalisation. Whilst certain markets have offered exceptional returns, others, such as China, have suffered significant setbacks, meaning the aggregate index has been unable to produce price gains since the Global Financial Crisis. Before that, between the first day of 2001 and the final of 2007, the MSCI EM Total Return index compounded at an astonishing 23.9% per annum, whilst over the same period the US-focused S&P 500 Total Return index only managed 3.3% per annum. We believe there is the potential for this to occur again, as centres of population expansion utilise their mineral wealth to accelerate development at a rapid rate.

Demographics play a large role in determining economic growth. Whilst it can be instructive to look at the counter case, such as in Europe where slowing population growth has contributed to slowing GDP growth, the real evidence lies in countries with rapidly expanding populations. This is especially pertinent to nations where the working age population is growing as a proportion of the total. A population pyramid with a wide base, suggesting a largely youthful populace, coupled with a narrowing peak, indicating a lower level of elderly dependents, is the formula required to supercharge growth. A prime example of this is India, where a substantial working age population has been complemented by a catalogue of social and technological reforms spearheaded by Prime Minister Narendra Modi. As such, Indian GDP is currently growing at 8.4% and has continued to surprise to the upside.

In a much-anticipated election in June, Modi failed to sweep a majority in the Indian Parliament but has still been able to form a coalition government to continue his policies of financial inclusion, digitalisation and industrialisation. The election is part of a much wider story of emerging economies heading to the polls this year, with the outcomes capable of producing an inflection point in local markets. The importance in the medium-term of democratic elections that return stable governments committed to spurring investment in their nation, especially through attracting Foreign Direct Investment, cannot be understated. This capital can be allocated towards funding progress in structural initiatives such as the move towards a carbon-neutral world, in which many EM countries hold an inbuilt advantage, being resource-rich.

The energy transition will require vast amounts of natural resources, with those nations rich in copper, nickel and other minerals essential for the global push towards net-zero likely to be beneficiaries. Copper is required in sizable quantities for the electrification of our energy system, being widely used in energy production and transportation. Yet copper deposits are mostly found in emerging market countries. For example, Chile, with its Andean mineral wealth, provides nearly 1/4 of the world’s total exports of the metal. Furthermore, the artificial intelligence (AI) revolution will also contribute to the growing use of the red metal and energy alike. Data centres used to train AI models and then respond to user’s queries demand considerable amounts of energy to process these requests, while the requisite infrastructure for such power requires large quantities of copper. Goldman Sachs estimates the annual energy usage of AI to be equivalent to the Netherlands’ yearly consumption by 2027, representing a quadrupling from 2024 levels.

A more recent development is the enforcement of controls which encourage the benefits of mining and processing to accrue domestically, rather than to the mining conglomerates who extract their resources. While this has happened before, as in Botswana with diamond miner De Beers, other countries are getting in on the act. Indonesia, a country rich in nickel, has ensured that raw nickel ore cannot be exported, instead only allowing it to leave the country once processed. This form of protectionism ensures that the value-add activities usually reserved for more developed economies are happening in-situ, with the associated economic benefits distributed in emerging market economies rather than to external recipients. Indeed, while labour force growth and mineral wealth fire the starting gun for growth in emerging markets, second-order effects, such as this, can be much greater.

Countries which harness their natural resources to attract capital benefit from a multiplier effect, with the profits usually leading to an expansion in consumer credit and to increased consumption. A growing middle-class often emerges, for whom there exists discretionary income that can be spent on increasingly luxurious goods. A similar middle-class has also emerged in China, where citizens desire progressively more advanced goods. However, we see that there is still room for this trendto continue, with Chinese private consumption only representing 37% of GDP, as compared to 68% in the US. We believe a focus on consumer-facing companies in emerging markets has the potential to offer strong returns as wage levels increase. A further beneficiary of rising GDP per capita is the financial sector, where the use of banking services tends to increase in tandem with GDP. Here again, the opportunity remains immense, with, for example, only a quarter of consumers in Egypt holding a bank account.

One feature of the recent inflationary impulse since Covid has been the trend of reshoring supply chains. Much of the impact has been focused on emerging markets, with countries like Mexico benefitting from the trend of bringing manufacturing back to politically friendly countries that are geographically immediate. Only recently, we have seen the percentage of US imports from Mexico overtake those from China. Developed markets have looked to diversify the producers of their consumer goods more broadly across a range of nations to ensure that no single issue, such as the extended lockdowns in China, can lead to the shutdown of the entire supply chain. Many firms have made the decision to move production centres away from China to countries like India and Vietnam to avoid the potential impacts of trade wars, among other issues. Thus, there are opportunities to be found in the new manufacturing centres of the world, where cheaper labour costs and less confrontational politics make for sound destinations for global manufacturers.

The fiscal and monetary conditions of many emerging market countries offer another reason to invest in their markets. In general, EM central banks were quick to hike interest rates in the face of rising inflation, thus avoiding the worst of the inflationary problem that developed markets faced. At the same time, they maintained a better sense of fiscal responsibility, avoiding overly stimulative fiscal policies. Thanks to this, debt-to-GDP ratios remain at reasonable levels and provide little cause for concern, which has the effect of providing stability to emerging market government finances and their respective financial markets. For example, the Central Bank of Chile hiked interest rates approximately six months before the Federal Reserve, breaking the back of inflation early. This move allowed the bank to cut rates as early as mid-2023 to pursue growth, with the stock market responding positively.

This confidence to avoid following the tune of developed markets has established itself in other ways too. The more assertive temperament developing in emerging countries is evident, with their own agency becoming increasingly important to them as sovereign nations. In a multipolar world in which the US and China dominate, many emerging markets are choosing to sit in the middle, picking neither side while playing both. In the case of India, cheap Russian oil has helped power growth to new levels, yet the country is also a ‘Major Defense Partner’ of the United States. This autonomy, characterised by something of an indifference to global geopolitics, is allowing many emerging market nations to enjoy the benefits of interaction with both the global leaders and their respective allies.

On a final note, emerging markets remain attractively valued and provide diversification benefits for a portfolio too. For instance, the forward price-to-earnings (P/E) ratio of 18x for developed market equities is 50% higher than that of emerging market equities at 12x. This discrepancy provides investors with an opportunity to buy into high-growth companies at a lower cost than they would incur in more developed economies. If market efficiencies improve and international investors recognise these opportunities, we believe valuations are likely to rise, leading to significant returns. This potential capital growth can come without correlation to developed markets, allowing investors to diversify risk while retaining access to high growth opportunities. For example, the correlation between the S&P 500 and MSCI EM indices is just 0.51, where a value of 1 indicates total correlation and 0 none. Further to this, not only do emerging markets have a relatively low correlation to the largest developed equity market, the US, but they are also uncorrelated to each other, which is why we minimise country-specific risk by investing in a diversified mix of these nations.

It strikes us that emerging markets need not remain ‘emerging’. The faltering demographics and stretched balance sheets of developed countries should encourage long-term investors to look to capital markets elsewhere. More alluring then are those countries on the cusp of a breakthrough, where population growth, often coupled with an abundance of mineral resources, have the potential to lead to explosive growth. We see plenty of opportunities to buy rapidly growing companies in stable markets at knock-down valuations, while secular trends like net-zero look likely to provide tailwinds for emerging markets long into the future.

Lincoln Private Investment Office