Andrew Van Sickle: After more than a decade of poor performance, emerging markets (EMs) have staged a comeback this year. The benchmark MSCI EM index has gained more than 20% in US dollar terms. What has brought out the bulls?
Gustavo Medeiros: I think there are three key drivers here. The first is that we had historically low valuations at the start of the year. The second is that over the last 18 months or so, earnings per share have started to climb, helped by healthy growth in several countries and buoyant industries such as AI and semiconductors.
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Andrew Van Sickle: That usually bodes well for EMs, which are risky assets; a buoyant greenback, along with high US interest rates, bolsters the appeal of safer US assets. Have global investors become disillusioned with America?
Gustavo Medeiros: America has the world’s reserve currency and the deepest capital markets in the world. So the key determinant of global asset allocations will be how the biggest market is performing in absolute and relative terms. High valuations and the tariffs on “liberation day” unnerved investors, reminding them that they needed to diversify away from the US. Structural improvements in developing economies, notably lower inflation, and a shift to pro-market policies post-pandemic, have also helped bolster sentiment. There have been more upgrades than downgrades of EM sovereign debt for some time now, for example.
Meanwhile, although EMs are traditionally comparatively dependent on trade, with large shares of exports as a percentage of GDP, Liberation Day at least tempered the uncertainty. It became clear that tariffs would not fall below 10% but were also unlikely to exceed 30%. On paper Mexico and Vietnam are the most vulnerable, with exports to the US worth 25% of GDP in each case – although a pre-existing Trump-originated deal in the former, and a strategic partnership with the US in the latter, tempers risk. Their stock markets have rallied 40% this year, as have those of Southeast Asia, the next most vulnerable economies.
Andrew Van Sickle: Shall we take a closer look at the structural changes in EMs, a recurring theme for 10 to 15 years now? Everyone used to think of EMs as commodity-exporters heavily geared to global growth, but there’s far more to the story these days.
Gustavo Medeiros: Yes, there is a wide array of supportive factors. In Asia, India and Indonesia are two examples of major economies that have gained momentum through structural reform. Chinese technology, chipmaking in Taiwan and AI are also boosting EM growth. In Latin America, there are many high-quality undervalued companies that have embraced digitalisation and have enormous target markets, yet politics has obstructed the investment opportunity. A series of coming elections are likely to result in a shift towards a more free-market approach, which bodes well for profits and interest from global investors.
Peripheral Europe and central Asia should benefit from a strong boom in capital expenditure on defence, energy and infrastructure coming from Europe, a result of Europe’s attempt to become more self-sufficient. Meanwhile, a round of fiscal consolidation in Ghana, Nigeria and Egypt, following the tight squeeze imposed on Argentina by president Javier Milei, is good news for some of the smaller, more exotic markets.
Andrew Van Sickle: I remember being struck, during the pandemic, by EM central banks being quicker off the mark when it came to squeezing out inflation by raising interest rates than their developed-market counterparts. Overall economic management has improved greatly in EMs.
Gustavo Medeiros: Economic policy has been much better, much more sensible over the past five years in EMs. They raised rates rapidly to counteract the global boost to inflation and avoided quantitative easing; they were mostly restrained when it came to fiscal stimuli, too and quicker to consolidate their deficits. They clearly learnt from the debt crisis of the 1980s and 90s and opted for prudence this time. That leaves them well-positioned for strong and sustainable growth.
Andrew Van Sickle: Let’s zoom in on some of the major economies and markets now, starting with China. A drift towards authoritarianism and the fear that it could turn into another Japan have been two key bearish factors. How would you assess the situation?
Gustavo Medeiros: One simply has to factor in that China has a different political system. The key is the extent to which the private sector is allowed to flourish. And here, the news has improved over the past year. We have become more optimistic recently. Since last autumn, policymakers have been far more willing to support enterprise. It started with measures to backstop the real-estate sector, which has been a major drag on activity. Then the central bank allowed firms to borrow cheaply to buy back their undervalued stocks, accelerating a trend towards buybacks that companies had started themselves. That was a key turning point for us.
The state is also supporting developments in technology, with DeepSeek’s large language model being rapidly adopted in both the public and private sectors. The government hopes to harness AI’s potential to accelerate progress in areas where China is already leading, such as robotics, electric vehicles and cutting-edge biotechnology. The big picture is that the government used to favour particular industries, but now seems to be keen to bolster the entire private sector.
And this is very important. The main reason countries get stuck in the middle-income trap is a failure to innovate, not adverse demographics or other factors. This is clear to Beijing, which is why the leadership keeps on pushing to make their economy more productive, and keeps on pushing to be at the forefront of technological development in many industries. Beijing is also acutely aware that some sectors are oversupplied, with rampant competition rendering margins razor-thin. The banks have fuelled the boom in capital expenditure, and could now take measures to help sector leaders buy up less productive rivals and perhaps rein in lending to struggling mediocrities. The least productive companies should gradually fall by the wayside. These measures are meant to address fears over the Japan-style zombiefication of the economy.
Andrew Van Sickle: Very encouraging. Taiwan is still the second-biggest weighting in the MSCI EM index. That’s due to chip giant TSMC, isn’t it? It’s the AI story.
Gustavo Medeiros: It has the tightest grip on the sector thanks to its ability to produce cutting-edge chips economically, with cutting-edge equipment. It would take years and a vast amount of capital for another company to emulate them, so that provides the company with an enduring competitive advantage; a deep “moat”. While Google could face a threat in search and Apple would struggle if another firm comes up with a gadget that is better integrated with AI than Apple’s range, I don’t see TSMC’s lead being eroded anytime soon.
Andrew Van Sickle: Let’s look at India, which you have described as the most exciting structural-growth story in EMs.
Gustavo Medeiros: No exciting structural story goes in a straight line, and there are now some wrinkles in the case of India. Around 18 months ago, valuations became extremely overpriced, which has been a headwind. And the pace of growth in capital expenditure, having surged in prime minister Narendra Modi’s first term as investment in infrastructure galvanised investment in the private sector, has ebbed.
A bright spot at present is the banking sector. Valuations are reasonable, private banks have done well with the adoption of fintech and have been able to deliver strong growth. Meanwhile, inflation is under control and short-term interest rates have been cut. The interest-rate curve is thus steepening, which is good news for banks’ net-interest margins. President Donald Trump’s tariffs are another headwind for now, although the economy is relatively insulated from global trade, given the large consumer sector.
The long-term outlook is still favourable, however, given the demographics, the dynamic private sector (the service sector will be able to exploit AI) and the gradual evolution of a manufacturing sector in recent years. Apple, for example, have said they will make all iPhones sold in the US in India by 2030.
Andrew Van Sickle: Finally, you have described Indonesia as a structural-reform story trading at crisis-level valuations.
Gustavo Medeiros: A year ago, power was transferred to president Prabowo. He is market reform-orientated, like his predecessor Jokowi, but investors appear to have been spooked by two policies. One was free school meals. This is sensible, but it took up a large share of the budget in a traditionally low-tax, small-government economy.
Then he consolidated state-owned companies into a sovereign wealth fund in order to gather their dividends together and allocate the money to the economy more effectively. Again, sensible enough, but investors were nervous because of the recent scandal surrounding Malaysia’s 1MDB sovereign wealth fund. Just as investors were starting to digest the uncertainties, the protests on the streets of Jakarta led to the exit of experienced finance minister Sri Mulyani. She was seen as one of the safest pair of hands across EMs, so even though her successor is likely to keep her policies unchanged, her exit was another blow to confidence.
Still, the broad pro-market direction is unchanged, and the long-term structural-growth story remains compelling. Indonesia has lots of metals that will be crucial to the global energy transition, while demographics are also a tailwind.
This article was first published in MoneyWeek’s magazine. Enjoy exclusive early access to news, opinion and analysis from our team of financial experts with a MoneyWeek subscription.
