8. Emerging markets have the wind in their sails

Strong valuations
Emerging market equities are currently priced at a discount relative to developed markets (Figure 11). While such a discount is normally the case, it is wider than on average and we expect that it will attract capital inflows, especially in an environment of low global interest rates.

A weak US dollar
In an environment of moderating inflation and trough interest rates, we expect the US dollar to be generally stable to lower in the year ahead. Historically, emerging market equities have fared well against a lower/stable dollar trend, as it reduces dollar-denominated debts and makes local assets relatively more attractive.

Fiscal discipline
Emerging market economies are often incorrectly assumed to face higher debt burdens than advanced economies. In fact, many of these economies have become fiscally disciplined over the last few decades, learning lessons from previous debt crises such as the Tequila Crisis of 1994. Now, countries such as Mexico, Brazil and India face gross government debt levels as a percentage of their GDP lower than those of advanced economies such as the US, UK, France and Japan.

Emerging market domestic demand resilient
In emerging markets, domestic demand resilience and strong consumer spending remain important pillars of growth. This is most notably the case in India, whereas in China consumer demand is still restrained as a result of a debt overhang, a weak housing market and poor consumer confidence. Even so, China still remains key to overall emerging market developments. It has outsourced production to smaller economies (for example Vietnam) and has helped build infrastructure around the world under its Belt and Road Plan – even though that is now more constrained in its ambitions.

Commodities
In addition to domestic demand forces, several emerging markets are commodity exporters. Favourable global demand or supply constraints for key commodities (minerals, metals, energy) could improve export revenues and fiscal balances.

A salient example is China’s rare earths dominance. The world’s second largest economy accounts for almost half of global reserves, two-thirds of global production and over 90% of global refining (Figure 12). China has been strategically building these capabilities over decades. A famous quote from former leader Deng Xiaoping in 1992 highlights this point: “The Middle East has oil and China has rare earths”.

Rare earths are versatile, entering supply chains for products ranging from loudspeakers and X-ray machines to missile guidance systems. They are also used in the production of high-tech hardware that AI relies on and will benefit from the AI race. Additionally, the transition to clean energy may raise demand for critical minerals (lithium, cobalt, etc.), benefitting emerging economies that host these resources.

Strong demographics
Emerging economies that have typically received less attention – notably those in the Gulf region – should continue to do well even as the world pivots away from the use of oil and gas. In particular, they should benefit from their commitment to substantial infrastructure projects and favourable demographics of younger and growing populations (notably female participation in the Saudi workforce).

There have been outflows of funds from emerging market fixed income markets since 2002 (and broadly flat equity flows over the same period). We think the above points set the scene for fund flows into emerging markets to increase and for emerging market performance to recover relative to developed markets.

Risks to recognise
As with any theme, there are risks that one should be aware of. Geopolitical tensions have been elevated in recent years and this remains the case today. If these tensions were to spike, a flight to safety could pause the weaker dollar trend that benefits emerging markets. This trend could also be arrested by a more hawkish Fed which fails to deliver on market rate cut expectations if US labour market or inflation data is stronger than expected. In addition, the overhanging threat of US tariffs is a prominent risk for the commodity exporting emerging market economies, threatening to disrupt trade flows and lower economic growth.