Q3 2024 CIO Review and Outlook

Volatility has been the watch word for many markets over the past quarter. Concerns over a U.S. slowdown, China’s struggles, the sustainability of the artificial intelligence (AI) boom and rising rates in Japan, have triggered sharp moves in sentiment and equity prices. Yet, emerging markets overall have performed well. Toward the end of the third quarter, we also had the 50 basis points (0.50%) interest-rate cut by the Federal Reserve and a raft of stimulus measures in China. The potential onset of a U.S. rate cutting cycle could provide a significant catalyst for economic growth and strong performance in emerging markets. 

Before delving into how some of our key markets performed last quarter, it’s worth putting some perspective around the Fed’s rate cut. Generally, there are two reasons for rate cuts, in our view. One is to return to a normalized monetary path and the other is to get economies out of trouble. In this case, we believe it is the former and solid U.S. economic growth is good news for the world economy and emerging markets. The Fed’s rate cut will also, we think, provide an impetus for a number of central banks to cut their own rates. It’s a significant turning point for emerging markets, particularly in Asia, in our view. Growth is picking up and Asia’s economies are also on a much more normalized cycle than in the U.S. because demand wasn't helped by fiscal policy and handouts. 

India: Balancing Consumption and Investment

Turning to specific markets, let’s begin with India. Equities are up more than 20% year-to-date, which is comparable with the U.S. The question is not so much, should investors get exposure to India but how should they get exposure to India, particularly given it is an expensive market with numerous investment options. 

Our view is that India is a long-term structural investment story. Under Prime Minister Modi, the country has been successfully building out its CapEx, infrastructure and transportation. However, in this year’s general elections, differences in income levels and employment prospects between regions and localities became a big political issue and was a key reason why Modi failed to secure a majority. In the last quarter we have seen signs that the new coalition government will bring more balance to the growth agenda which is a positive and should bring in more foreign investment, in our view.

India has incredible growth rates coming out of many areas and segments as they adjust or benefit from the changes and the broadening out of the economy. However, the perennial challenge for equity investors has been the rich valuations of stocks. Investors have to be prepared to pay more for businesses that they believe can grow and accelerate earnings and at the same time be cautious and mindful of liquidity and exuberance in pricing. It requires intense active management. Different sectors can offer different attributes. Financials, for example, is probably not going to be a key driver of India’s growth but firms in this sector are winning market share. On the other hand, consumer discretionary companies will likely be significant beneficiaries of the wealth effect as consumer purchasing power increases.

Overall, we think India’s growth story will continue to evolve and widen. There will likely be corrections but these could also be good long-term buying opportunities.

“In many emerging markets, the growth theme is domestic economic expansion rather than U.S. technology-driven growth and we believe this has the potential to give investors attractive risk-adjusted returns over the next few years.”

Volatility and Opportunity in Japan

After 12 strong months, Japan’s markets experienced extreme volatility in late July and early August, culminating in a sharp selloff and then fast recovery after the Bank of Japan (BOJ) raised interest rates and then quickly sought to assuage investor concerns over its macro policy. Since then, the BOJ has been less assertive in signaling more rate hikes are on the way. It remains to be seen how that may change following Shigeru Ishiba’s unexpected victory in the ruling Liberal Democratic Party’s leadership contest and his decision to hold an early general election on Oct. 27.

We believe recent market volatility leaves Japanese equities in a good position. They are cheaper than they were before the sell-off, it remains a market that is under-owned and earnings are robust. However, while companies’ earnings are less sensitive to currency moves than in past—partly because more Japanese companies with international revenue operate overseas hubs in local currencies—the macro picture can still drive returns in the short term. So we have to be cognizant to the sensitivity of the market to movements in interest rates and the yen.

Longer term, the recent drivers of returns in Japanese equites—earnings growth, capital market reform and corporate governance changes—are still intact. For active investors in Japan, we would also say that short-term volatility can give entry points to add to what we think are truly good fundamentals-driven long-term stories.

North Asia

Staying in North Asia, with much of its economic growth embedded in the global semi-conductor supply chain, Taiwan’s market performance is very much tied to the fortunes of large U.S. AI-orientated tech firms. In recent months, this has been a source of volatility amid concerns over the sustainability of the AI boom. In an environment of falling U.S. interest rates, we would typically look at gaining more exposure to Taiwan because of its ties to the global economy. However,  we think it is time to be selective as many company valuations have become stretched due to the AI theme.

In South Korea, we are seeing a Japan-style corporate governance pick up. Improvements are slow but they are moving along. Going forward there are areas that we are a little bit cautious on, including autos, because of pricing pressure and softening demand. We need to be confident that the earnings are continuing to come through and then we can look for attractive opportunities.

China: a Stock Picker’s Market

China's economic difficulties are well documented and in the last quarter we continued to see a deterioration in consumer sentiment and month-on-month declines in property prices. However, many Chinese companies have shown resilience. While earnings have disappointed in many areas, there have been notable exceptions, particular in e-commerce, where there has been a focus on the bottom line and improvements in profitability rather than purely on sales growth. Valuations are very cheap in this segment and generally companies have strong balance sheets, have a lot of cash and are still able to cut costs. 
Companies more directly tied to China’s domestic economy and the property market face greater challenges. Earnings growth is struggling to get a footing and valuations are reflecting that. Among retailers, for example, we are seeing margins coming down as companies try to maintain volumes. There is a de-premiumization occurring as consumers are spending but they're much more selective in what they are spending on.

The stimulus moves announced by China’s central bank in September, which included monetary easing and mortgage rate cuts, further efforts to reduce real estate inventory and stock market boosting measures, were broad and positive and triggered a sharp rally in China’s equity markets. However, time will tell whether these measures will contribute to a notable and sustainable improvement in China’s economy and property sector or whether further stimulus and actions are warranted. While valuations currently look compelling, earnings projections are changeable and some stocks could remain attractive while others could become expensive.

Rate Sensitive Markets: Southeast Asia and Latin America

In Southeast Asia, markets have be driven by a combination of domestic politics, domestic growth and the external macro environment as these economies are generally sensitive to U.S. interest rates. In terms of politics, there have been changes in recent years in markets including Indonesia, Malaysia and Vietnam, and generally we would say these changes are adding stability and in some cases opportunities for reform. The region’s domestic growth is also coming through and we have seen that in equity market performance this quarter. We think this economic growth can be further fueled by a potential cycle of U.S. rate cuts with the prospect of a weaker U.S. dollar. We view the markets of Vietnam, Malaysia and Indonesia as having the strongest prospects whereas in Thailand we need to see some political stability and see more growth emerging.

Latin American markets tend to be rate-sensitive as well but there are country-level issues. Mexico has lots of potential growth in the long term, in terms of its trade with the U.S. and in many areas such as financials and consumer segments, but the risk premium continues to be high because of political uncertainty. With a new president elected in early June, we will have to wait to see what kinds of policies will be implemented and how they affect the private sector. This is making investors very cautious and has weighed on equity market performance and sentiment this year. Brazil is going through a different situation. Inflation remains a challenge; hence the pressure on interest rates is upward not downward. However, the country has a new central bank governor and we think he will work to restore credibility in the bank and the economy. In the short term, this will likely mean that rates will go up but then should take a downward path.  

Looking Ahead 

For the remainder of the year and beyond, we expect market volatility to continue, particularly as we approach and pass through the U.S. election. But over the medium term, we see earnings growth picking up and valuations remaining reasonably cheap. We're also seeing more broader potential, in Southeast Asia as well as in South Korea and Taiwan—as the latter two go through a slight de-rating we will be looking for opportunities. In addition, we see long-term areas of potential in Latin America.

Stepping back, we don’t think investors should be pre-occupied with timing a recovery or period of upside in emerging markets. Instead, we would advocate the importance of a diversified portfolio. In our view, the earnings growth and stock market returns of emerging markets over the next five years will start to resemble that of the U.S. in recent times. If the performance of the U.S. starts to go below trend in the medium term, we think Asia and emerging markets can fill the gap.

Notably, in many emerging markets, the growth theme is domestic economic expansion rather than U.S. technology-driven growth and we believe this has the potential to provide investors with attractive risk-adjusted returns over the coming years.

Sean Taylor
Chief Investment Officer