After a decade of disappointing performance, the years ahead look more promising for emerging markets (EMs) thanks to a confluence of cyclical and structural factors in the region, according to Newton’s recently appointed head of emerging markets and Asia equities, Liliana Castillo Dearth.

One of the reasons Dearth is optimistic is because she notes from a cyclical point of view, the growth differential between EMs and developed markets (DMs) is improving. She observes how growth in the DM world is starting to decelerate while growth in EMs remains relatively resilient, reversing a trend that has been prevalent for the past decade.

Dearth also sees positive structural developments in EMs. She says the challenges of the past decade have brought significant innovation in products and services from companies across the region to meet growing and evolving demand.

Growth in China remains “a big question mark”, adds Dearth, noting the country’s disappointing reopening after Covid lockdowns. But she says there are signs of a cyclical bottoming which is positive moving into 2024.

Strength and resilience

“At company level across EMs, I see stronger balance sheets and resilient management teams that have learnt to operate in a challenging environment,” she adds. “This translates into unique investment opportunities with long runways of growth, addressing evolving domestic needs across emerging markets and in some cases, taking share in global industries.”

Dearth views this in the context of what she sees as attractive equity valuations in EM markets. She notes global emerging markets (GEM) equities are trading at a compelling level relative to history compared with developed markets.

Inflation

Dearth argues it is also important to consider inflation in EMs from both a cyclical and structural perspective. She says on a short-term cyclical basis inflation is starting to moderate across emerging markets with several central banks in the region having led the trend in cutting interest rates. Additionally, she adds, with the Federal Reserve potentially holding interest rates, US dollar strength could moderate which would be welcomed by EMs.

Dearth says we are structurally in a regime where inflation will remain higher. One driver of this is the growing need for resilience and diversification of supply chains. This is likely to drive investment in local industries as illustrated by, for example, the China-plus-one strategy. “This drives higher pricing and structurally higher inflation, in my view,” she says.

Elsewhere, decarbonisation is a “non-reversible trend” that is also creating inflationary pressure, notes Dearth. But a higher inflation environment is one in which EMs are used to operating, she adds, whereas DM companies are still figuring out how to operate in this change of regime.

Geopolitical tension will remain, and a more volatile macro environment will likely drive a higher dispersion of returns, says Dearth. This, she adds, could be an attractive environment for active managers, particularly those looking for innovative companies within EM markets exposed to long term growth trends.

Themes

In terms of interesting growth trends in EMs, Dearth points to industrial automation, noting ageing populations and labour shortages as driving forces in countries like China. One way to play this is through manufacturers of the equipment that is driving automation, she says.

Another interesting theme, Dearth says, is financial penetration. She says Indonesia is a market where access to finance is very low. Financial inclusion is key to driving higher participation of marginalised segments of the population in the economy. There is a big opportunity to provide forms of funding, such as micro loans to smaller companies and traders, she concludes.

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