Navigating International Allocations – Global X ETF

The MSCI Emerging Markets Net Index has outperformed the S&P 500 in only two of the past 11 calendar years ending in 2023.¹ However, during the most recent emerging markets (EM) cyclical bull run from 2001 to 2010, the MSCI Emerging Markets Index (net) achieved a cumulative return of 344.40% compared to 15.07% for the S&P 500 Index.² This raises the question of whether emerging market stock markets are in the midst of a new cyclical upswing. While we refrain from passing any definitive judgement on the collection of 26 countries, economies and political systems that fall into the “emerging markets” category, we do point to several different positive indicators.

Where are we?

• request: The market hit the peak of Federal Reserve (Fed) rate-cutting rhetoric in January 2024. Since then, copper, gold, oil and emerging market assets have counterintuitively risen despite gradually increasing hawkish rhetoric, rising yields and a stronger US Dollar (USD). We believe this is an indication that the market is driven by structural supply-demand factors, expansionary Purchasing Managers’ Index (PMI) numbers and a recovering capital investment cycle, not just interest rate speculation. If the Fed starts to cut rates, it may add fuel to the fire. JP Morgan’s Global Manufacturing PMI index has been above 50 every month this year and has been trending up until May (it has been in contractionary territory for 16 consecutive months and is well below the previous cycle peak of 55.5 in June 2021).³

• Dollar: We believe the US Dollar is the most influential driver of overall emerging market equity market performance. Historically, emerging market equities, as measured by the MSCI Emerging Markets Net Index, have exhibited an inverse correlation with the US Dollar (roughly 4% gains for every 1% decline in the US Dollar).^Four This correlation is due to both:
  • the inverse correlation between the US dollar and commodity prices, and
  • Emerging markets and the companies within them have historically funded their growth with US dollar-denominated debt.

When formulating a view on the dollar, it is important to consider the following factors:

• • The Federal Reserve has signaled a possible end to its monetary policy hike cycle. Lower interest rates essentially attract less capital, which could reduce demand for the US dollar and result in it becoming weaker.
  • An uncertain and polarized election cycle in which both presidential candidates have demonstrated a penchant for increasing spending and increasing the U.S. budget deficit.
  • As “imminent” government shutdowns become the norm, trust in key institutions is declining.

• evaluation: Despite rising gross domestic product (GDP) growth, emerging market stocks are trading at more than one standard deviation below their historical average discount to developed market stocks.^Five The emerging market stock market as a whole trades at a price-to-earnings ratio of 11.18, compared with 19.42 for the S&P 500, which offers a dividend yield of 2x and a higher expected growth rate.⁶

I’m looking forward to

We have noticed a significant increase in interest in emerging markets. Many investors are looking for differentiated ways to find significant growth at cheap valuations, going from little to no exposure to the asset class. Some are looking for USD hedges, many are looking for potential alpha, and some are simply looking for diversification. We see a range of opportunities in the asset class, but our most excited are India from a long-term structural perspective, Brazil facing a potential 6-12 month cyclical upside, Argentina as a high risk/reward inflection point, and Greece as a way to unlock significant value. We are neutral on China given the limited outlook for the overall market, but see bright spots in domestic consumption.

• Asia: While we started the year with a call to “be greedy when others are fearful” in our China 2024 outlook, we now remain selectively optimistic on the Chinese equity market, and Chinese consumption in particular. Generally speaking, a combination of a low earnings base, a normalizing economy, and continued stimulus could drive a positive EPS revision. However, we also see headwinds at home. The US election cycle could lead to more hawkish rhetoric on China’s trade and military activities, while regulatory uncertainty around certain sectors could also scare investors away. From a valuation perspective, after a rally year-to-date, the broad MSCI China Index is trading in line with its five-year average.⁷ That said, we believe China’s consumer sector represents a unique opportunity. India has the strongest secular structural story among emerging markets and we believe there is still opportunity for earnings upside. Southeast Asia and Vietnam are also attractive from a structural perspective. On the cyclical side, we see opportunities for Taiwanese and Korean companies to continue to benefit from surging semiconductor demand, but we are wary of political headwinds, trade disputes and ultimately a slowdown in U.S. demand.
• latin america: Latin America is home to a diverse range of economies with significant exposure to commodities trading at discounted prices. Brazilian equities came under pressure in the first half of the year, but we believe there is room for optimism going forward. We see further room for the central bank (COPOM) to continue its accommodative policy cycle, and lower interest rates could encourage inflows from the domestic bond market into equities, lowering floating-rate borrowing costs and stimulating credit growth. Beyond these near-term factors, Brazil remains a commodity powerhouse, exporting oil, gas, iron ore, soybeans, protein and other products around the world. Mexico still benefits from positive real interest rates and “nearshoring” tailwinds, but the recent elections saw the Morena party gain unprecedented power, raising the risk of controversial constitutional reforms, pressure on fiscal balances and economic headwinds. In the Andean region, we expect the high copper price environment will continue to be a boon for both Chile and Peru, which will produce about a third of global supply in 2022, supporting their currencies and potentially leading to increased consumption.⁸ While the political backdrop in Colombia remains challenging, the market’s recent rally could continue into the second half of the year due to weak equity valuations, weak investor positioning and the country’s excessive exposure to oil.
• Emerging Europe, Middle East and Africa (EEMEA): This vast region offers investors diverse opportunities. In emerging Europe, we are optimistic that a combination of easing inflation, monetary easing and lower policy rates could support accelerated growth for the rest of the year. EU Recovery and Resilience Facility (RRF) funds are also starting to flow to countries, governments are maintaining consumer-friendly policies and the European Central Bank (ECB) cut interest rates for the first time in June. In the Middle East, we see secular themes continuing to play out. In Saudi Arabia, the government must balance capital expenditure plans for large projects as well as global crude oil markets to meet growing fiscal needs. Other Gulf Cooperation Council (GCC) countries are also pushing strong reforms as they compete with Saudi Arabia for investment and growth in the region. Importantly, the region benefits from a peg to the US dollar, which could, counterintuitively, be a haven within emerging markets despite broader geopolitical risks. South Africa is likely to perform better in the second half of the year with the recent formation of a coalition government led by the ANC and the DA. With the coalition government leaning to the center, investors are likely to focus on fundamentals. Turkey is expected to maintain economic orthodoxy as the government pursues deinflation, which could support foreign exchange inflows and reserve accumulation. Egypt is on the path to macro stabilization, but risks remain, especially around currency.

Focus on opportunities

• structure: We see India as the best structural and long-term opportunity in the world, driven by attractive demographics, market-oriented (and democratically elected) governance, diversifying supply chains from China, and a growing middle class, all built on a unique “digital stack.” Vietnam is another structural story that could benefit from a strong demographic dividend and continued manufacturing diversification from China.
• Cyclical: We see two unique cyclical opportunities: From a concentrated perspective, we believe Brazil is particularly attractive due to cheap valuations, a developed monetary policy cycle, and broad exposure to a solid commodity fundamentals. From a currency perspective, Brazilian equities have historically delivered returns of around 5% for every 1% decline in the US dollar.⁹ For a more diversified approach, we believe emerging markets ex-China offer balanced exposure to commodity and interest rate stories in Latin America and Eastern Europe/Middle East/Africa, as well as burgeoning artificial intelligence technologies in North Asia.
• value: We believe Greece and Colombia are unique emerging market countries with great value. Despite their geopolitical neutrality, market-friendly governments, and strong economic momentum, Greece is still trading at less than 1x book value, trading at a robust P/E of 6.93 and a dividend yield of 6.75%.^Ten All three agencies have raised Greece’s credit ratings to investment grade and see potential for an upgrade to developed market status over the next three years. Greece is expected to grow about 3% this year, well above the euro zone average of 0.8%.¹¹ Columbia’s stock is trading at a low 0.76 times book value, a P/E ratio of 5.70, and a dividend yield of 8.48%.¹² Markets are already pricing in adverse reforms, but we see political gridlock and a path back to the center. Moreover, rising energy prices could be a strong tailwind for the economy.
• Opponents: The consumer sectors of Argentina and China offer two interesting contrarian opportunities in emerging markets. Six months into his term, Argentine President Milley has made great strides in putting the Argentine economy back on track, passing major economic reforms, devaluing the currency and cutting irresponsible government spending. The country is already running both fiscal and trade surpluses, and reform progress is expected to continue this year. This momentum could further boost the president’s popularity heading into the 2025 midterm elections. In China, falling home prices, weak global demand for goods and high unemployment have weighed on the Chinese consumer recently, driving valuation multiples more than one standard deviation below their five-year average.¹³ But the sector is unique in that it is strongly aligned with the Chinese Communist Party’s goal of doubling the middle class and promoting domestically led growth.¹⁴ Looking ahead to the second half of the year, Chinese consumer goods stocks (such as apparel, technology, autos and travel) look promising based on valuations, government stimulus and continued support for the real estate sector.
• theme: We believe the long-term evolution of emerging market economies from asset-rich, low-profit exporters to asset-light, high-profit domestic service and commodity providers is here to stay. History doesn’t repeat itself, but it often rhymes. Economic factors and the post-World War II “baby boom” led to a significant expansion of the U.S. middle class. The U.S. benefited from the 76.4 million baby boomers born between 1946 and 1964.¹⁵ With roughly 5 billion people expected to join the consumer population by 2031, Global X believes we will see similar divergent economic patterns across emerging markets.¹⁶ This megatrend, combined with reduced uncharted volatility on currencies, commodity prices and trade rhetoric, is raising optimism about the outlook for domestic consumption across emerging markets.