When the Federal Reserve System announced the tapering of quantitative easing in 2013 and Treasury yields surged, emerging market assets were heavily impacted as investors feared that ending these unorthodox monetary policies would trigger a massive sell-off in global markets.

In 2022, when advanced economies began raising interest rates to combat rising inflation, there was a fear that EMs would face a similar fate. However, this expectation proved incorrect; most EMs navigated the interest rate hiking cycle better than expected. Taking this turn into consideration, investors should reevaluate their allocation to emerging markets, as these assets remain largely underweight in global portfolios.

The case for EM assets can be made based on three factors: macroeconomics, asset allocation and valuations. The macroeconomic argument hinges on the positive growth differential between emerging markets and advanced economies, which remains intact despite China’s lower-than-expected growth (Figure 1). This growth differential is supported not only by the catching-up in income per head but also by important megatrends such as favourable demographics, the rise of the middle class, urbanisation, structural reforms and financial deepening and developing digital and energy transformations.

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Figure 1. Positive growth differential intact despite China’s low growth
Gross domestic product, diffential EM - AE (lhs) vs EM excluding China - AE (rhs)

Source: UBS

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The macroeconomic case also rests on improved macroeconomic stability and more effective macroeconomic management. Many EMs have moved away from the era in the 1980s and 1990s of double-digit inflation rates by switching to inflation targeting and central bank independence – in line with advanced economies’ best practice.

On the fiscal front, EMs have adopted a more conservative stance than AEs, resulting in slower growth in public debt amid the years of the Covid-19 pandemic. EMs have also shown an increased capacity to respond to external shocks; learning from past inflationary episodes, they began raising interest rates much earlier than advanced economies, thereby avoiding falling behind in the fight against inflation (Figure 2). Finally, improved macroeconomic stability and governance have improved the credit profile of many EMs.

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Figure 2. EMs learning from past inflationary episodes
Inflation differential EM versus AE

Source: UBS

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Second, the asset allocation case: EMs’ assets have underperformed between 2009-23 due to the very loose monetary and fiscal policy conditions prevailing in AEs, which led to a massive rally in asset prices. These conditions are now reverting with much stricter monetary policy conditions. Eventually, public debts will have to be reduced to more sustainable levels.

We expect EMs’ assets to outperform in the next decade with EM debt (in hard currency) generating higher annual returns than global equities (with less volatility) and EM equity delivering a return of nearly 10%, compared to 7.5% for global equities. As a result, the expected return of a standard 60/40 portfolio is expected to be nearly 2% lower over 5 and 10 years. EM-heavy portfolios are expected to return to pre-2008 financial crisis returns over the next five years, outperforming the standard portfolio by more than 1%.

Finally, the market case: With a forward price-earnings ratio below 14 for the MSCI Emerging Markets Index, valuations are considerably lower compared to AEs (in particular the US). In addition, a comparison of the price-to-book ratio shows that EMs are valued towards the lower end of the 25-year range, while the MSCI World Index is climbing towards highs last seen in the late 1990s and early 2000s.

Effects of deglobalisation

Will deglobalisation and protectionism impact EMs negatively as they face rising barriers to exports and find it more difficult to access vital Western technology?  The reality is that we are entering a new phase of globalisation rather than deglobalisation. First of all, the reconfiguration of international value chains to reduce Western dependency on China is a long and complicated process with uncertain outcomes. Many international corporates have signaled their willingness to stick to their international production model and so far, evidence of major corporates’ pull-out from China and other emerging markets is scarce.

What is certain is that there will be winners and losers in the new era of globalisation. Economies with better demographics (e.g. India) and costs advantages – for instance, better access to energy sources (e.g. Saudi Arabia, Nigeria) – are in a good position to benefit from the reconfiguration of global values chains. Some economies will benefit from their proximity to large Western consumer markets (e.g. Mexico, Turkey) and some other can tap into the global pool of talents (e.g. Malaysia, China and the Philippines). In this new phase of globalisation, investors will have to be more selective across markets and regions as there will be more dispersion in terms of economic performance and assets’ prices.