Emerging Markets: From Danger Zone to Opportunity? Why Investors Are Looking Beyond the US

Emerging markets in Asia, Europe, and Latin America are rapidly shedding their risky image, drawing significant attention from global investors seeking diversification and growth potential. This shift is driven by factors including changing US trade policies, the outlook for the US dollar, and inherent growth drivers within these economies. For British investors, ignoring this trend could mean missing out on crucial diversification opportunities.

Key Takeaways:

• Emerging markets are increasingly viewed as attractive investment destinations.
• US tariffs and potential Federal Reserve interest rate cuts are driving interest away from the US.
• Long-term growth factors like demographics and policy reforms support the bullish case.
• Specific opportunities and risks exist across diverse regions including Asia, Latin America, and EMEA.
• Funds and investment trusts offer accessible ways to gain exposure.

Why Emerging Markets Are Gaining Traction

For years, emerging markets were often perceived as volatile and risky. However, recent months have seen a notable change in sentiment. Amid concerns about potential trade wars and the impact of protectionist policies, particularly from the US, investors are actively searching for markets with less direct exposure to these pressures.

Wall Street investors, wary of how US tariffs could affect the domestic economy, are increasingly exploring territories where such policies may have a different, potentially less negative, impact. Emerging markets appear to offer a compelling alternative, presenting valuations often considered more attractive than developed markets, alongside unique growth prospects.

Industry experts highlight fundamental strengths. Patricia Ribeiro of American Century Investments points to “long-term structural growth in emerging market nations… fuelled by favourable demographic trends, such as younger populations and rapid urbanisation – and by reforms to policy and regulations.” These underlying drivers suggest potential for sustained economic expansion independent of short-term political shifts.

This evolving perspective is reflected in market performance. The MSCI Emerging Markets Index has outperformed the US S&P 500 index year-to-date, indicating a tangible shift in investment flows and confidence. This performance could have been even stronger, according to Chetan Sehgal, co-manager of the Templeton Emerging Market trust, were it not for lingering apprehension about tariffs, particularly impacting Asian markets.

Key Factors Influencing the Outlook

Beyond structural growth, several macroeconomic and political factors are influencing the appeal of emerging markets.

Tariffs and Trade Wars

The spectre of renewed or increased tariffs from the US remains a key variable. With deadlines for trade negotiations looming, some countries face the potential reimposition of double-digit levies. While this presents a risk, the impact varies by country. For instance, some Latin American nations may face lower tariff rates, and others are proactively navigating the situation. Mexico, for example, under its new president, has shown a pragmatic approach in its dealings with the US, recognising the critical economic ties between the two countries.

Meanwhile, South Korea, despite potentially facing tariffs, could benefit as some firms look to shift manufacturing operations away from China, presenting opportunities for alternative production hubs.

The Dollar’s Role and Interest Rates

Speculation surrounding the future of US monetary policy, particularly the position of Federal Reserve Chairman Jerome Powell and the potential for earlier interest rate cuts, is also a significant driver. Looser US monetary policy could lead to a weaker US dollar. Historically, a weaker dollar has often coincided with periods of strong performance for emerging market assets, making borrowing cheaper for these nations and potentially boosting their exports.

Rob Burdett of Nedgroup Investments notes that a “weakening of the dollar which, historically, has coincided with good times for emerging market shares” could serve as a catalyst to “trigger the unlocking of emerging markets’ potential for investors.”

Mexican president Claudia Sheinbaum and skyscrapers in Dubai

Navigating the Opportunities and Risks

Despite the renewed optimism, potential investors should remain aware of the historical volatility and unique risks associated with emerging markets. The “BRICS” narrative earlier this century, which saw mixed results with only India consistently delivering robust growth, serves as a reminder that not all emerging markets perform equally. Russia is currently isolated, while Brazil and China have faced various challenges, although their recent outlook has improved. The Shanghai Composite index has seen gains this year, partly attributed to trade dynamics and advancements in AI.

If you are looking to diversify globally, understanding the landscape across different regions is crucial.

Asian Technology Powerhouses

Many emerging market funds heavily favour Asia, with a focus on China, India, South Korea, and Taiwan. Chinese tech giants like Alibaba, Baidu, and Tencent are popular holdings. However, the dominant player in this space, and a favourite among global investors, is Taiwan Semiconductor Manufacturing Company (TSMC). Despite geopolitical tensions with China, TSMC’s critical role in the global AI supply chain, manufacturing chips designed by companies like Nvidia, makes it a key holding for many. South Korean firms like Hynix, a major supplier of DRAM memory essential for computing, also feature prominently, benefiting from the wider tech ecosystem. Political stability in South Korea has improved, adding to its investment appeal.

Latin American Potential

Latin America presents a mixed picture but offers specific opportunities. While some countries face potential tariffs, the overall rates may be lower than those applied elsewhere. Brazil, despite its history of high interest rates, inflation, and political turbulence, is seen by some fund managers as having potential, particularly if a more centrist government is elected in the future. Brazilian banks such as Banco Bradesco, Itau Unibanco, and XP are highlighted as well-managed institutions. Mexico’s banks, like Grupo Financiero Banorte, are also considered solid prospects.

Europe, Middle East, and Africa (EMEA)

For investors seeking to diversify away from potential China-related risks, the EMEA region offers alternative adventures. The Barings Emerging EMEA Opportunities trust, for example, focuses on markets like Poland and the Gulf nations. Poland’s economic fundamentals are improving, supported by factors such as increased defence spending and the return of skilled workers.

The Gulf nations – UAE, Saudi Arabia, and Qatar – are actively diversifying their economies away from oil through investments in tourism and infrastructure. The UAE, particularly Dubai, benefits from a favorable business environment and low taxes.

How to Invest in Emerging Markets

Investing directly in individual stocks across diverse emerging markets can be time-consuming and requires deep research into varying regulatory, political, and economic landscapes. For most investors, gaining exposure through diversified funds or investment trusts is a more practical approach.

Several reputable funds and trusts focus on emerging markets, offering exposure to a basket of companies across different countries and sectors. Options range from low-cost trackers following indexes like the MSCI Emerging Markets to actively managed funds run by specialist managers.

Examples of popular funds and trusts mentioned include Fidelity Emerging Markets (an index tracker), Artemis SmartGARP Global Emerging Markets Equity, FSSA Global Emerging Markets, JP Morgan Emerging Markets, TT Emerging Markets Equity, and Templeton Emerging Markets Investment Trust (Temit).

Before investing, it is essential to review the factsheets of these funds or trusts to understand their specific holdings, sector allocation, geographical exposure, and risk profile. This research helps determine if the investment aligns with your comfort level regarding geopolitical risks and exposure to specific regimes.

The Outlook: Moderate Returns, Significant Diversification

While emerging markets may not replicate the spectacular gains seen recently in parts of the US tech sector (like the “Magnificent Seven”), they offer the potential for solid returns. Experts suggest annual returns in the range of 7 per cent to 8 per cent, significantly better than current yields on government bonds.

The renewed interest from major Wall Street players underscores the growing recognition of emerging markets as a vital component of a diversified global portfolio. As global economic and political landscapes continue to shift, exploring opportunities beyond traditional developed markets could be a strategic move for investors this summer.