Fiscal dominance and the unexpected rise of emerging markets

When President Donald Trump fired the head of the US’s Bureau of Labor Statistics this month, claiming the department’s statistics were “manipulated for political purposes”, markets lurched in revulsion.

Commentators saw the US taking a large stride backwards from its status as leader of developed economies. The dollar immediately tumbled and gold prices jumped.

This reaction matters because investors worldwide were already nervous about owning too many US dollar investments. This news only energised a growing conviction by them to seek other places to put their money, including the emerging markets.

In particular, non-US based investors are asking whether the dollar has reversed its long trend upward since 2011.

“If the US succeeds in convincing the rest of the world that it cannot be relied upon then we should not be surprised if people take their own steps [to protect their portfolios],” says Alan Siow, co-head of EM corporate debt at asset manager Ninety One.

One of those steps has been to shift capital from the US into the emerging markets.

That may prompt some eye-rolling by readers, wondering just how many times this paper has suggested this idea. We had a go by foraging through the FT archives, but gave up counting.

Nevertheless, portfolio managers are definitely more interested in emerging markets. A big shift has occurred in the past month, according to Bank of America’s regular survey. What has encouraged this shift in sentiment?

On paper, there are sensible reasons to own emerging market debt and equities. Most EM countries have higher GDP growth rates and overall have younger populations, which together should theoretically inject more spending power into the pockets of their citizens. EM shares offer cheaper valuations than the rest of the world, especially the US, and EM debt can offer better total yield with less duration risk (sensitivity to interest rates). A weaker dollar, at a minimum, reduces the pressure on those central banks in developing countries fighting inflation.

However, experienced investors will have heard all this before. Since 2000, many of these emerging dynamos — such as India, Indonesia and Poland — have grown their real GDP faster than the US. But companies’ earnings per share growth have not consistently done the same in the past decade or so, due to occasional bouts of local currency weakness and various fiscal crises.

In fact, there have been too many one-off currency and fiscal crises to ignore. Previous success stories, such as China and South Korea, have in recent years suffered from political instability and sometimes poor corporate governance, reminding investors of the Asian currency crisis of the late 1990s. Meanwhile, nearly half of the benchmark MSCI EM equity index is in geopolitically risky China and Taiwan.

At best a decision to buy into these markets has been finely balanced. But for the first time in years the scales look set to tip towards EM and away from DM.

Why this time? One reason is that investors fret that leading economies, such as the US, Japan and the UK, have entered a new era of fiscal dominance.

Heavy debt loads among developed nations have led to persistently rising financing costs. That has put political pressure on central banks to reduce interest rates to offset these just when bond investors demand more government action on cutting fiscal deficits and raising taxes.

President Trump’s recent browbeating of the Federal Reserve about cutting interest rates is a prominent example. Fiscal dominance can undermine the reputation of central banks to control inflation.

When a government’s budget financing needs are put above the central bank’s objective of keeping inflation under control, bond traders worry more about whether governments will wrestle unsuccessfully with politically charged budgets.

“[High] debt strains political and social systems,” says Eric Fine, head of active EM debt at US investment management group VanEck. Many emerging market countries have already gone through the adjustment pains of holding too much debt, he believes.

It is true that many emerging economies have had to attack persistent inflation problems with high real interest rates. While borrowers in Brazil face a 9.5 per cent real long bond yield, according to UBS estimates, in the US this is at 2 per cent.

Such high yields have forced these countries to control fiscal spending to keep bond issuance to a minimum. Across EM current account deficits have shrunk from 1.8 per cent of GDP to 0.6 per cent since 2021, according to Ninety One asset management. In the US the same figure has widened to about 4.6 per cent, the most since 2008. Financing gaps have boosted US debt to GDP to 120 per cent this year, twice that seen across EM.

Investors may have finally taken note of these disparities among these economies. Disquiet has been building since Trump’s so-called liberation day and the market volatility that ensued. Since then, the dollar has acted as a barometer of sentiment towards US creditworthiness.

While a trade-weighted index of the US dollar had already peaked in January, the highest point as measured by Bank for International Settlements data in 30 years, its descent accelerated following the thunderclap from the April tariff announcements. Even if part of the dollar’s fall will have to do with expectations of rate cuts from the Federal Reserve, hopeful EM specialists do not see the dollar’s downdraft as short term.

“The dollar cycle . . . when it turns, this tends to last quite a long time,” says Gillian Edgeworth, macro strategist and EM debt portfolio manager at Wellington Management. “I think we’re in the early stages of a turn in sentiment [in favour of EM].”

Gustavo Medeiros, head of research at Ashmore, an EM investment manager, agrees. Moreover, he says “dollar weakening frees up capital in the emerging market countries”, as a stronger local currency enables respective central banks to consider interest rate cuts. That in turn reduces any rising debt servicing which acts as a drag on economic growth.

Note that inflows to EM debt funds (excluding exchange traded funds) were positive in the three months through July this year, the longest consecutive set of inflows for over four years, according to data from Morningstar. Riskier local currency debt funds have also attracted more money.

Moreover, ETFs of EM debt have received $36bn year to date, says Karim Chedid, head of Emea investment strategy for iShares at BlackRock. “This is at a record level and higher than in 2019, the previous record for EM debt.”

The renaissance in interest may have the greatest impact on emerging market equities, as global investors have avoided these for so long.

“What works in the 2020s?” asks Michael Hartnett chief investment strategist at Bank of America. “Monopolies, oligopolies and scale. But EM is tarred with the label of being small [while] a preference for large-caps keeps Europe as [first choice].”

That partly explains why global investors have shunned these assets. In the past decade they have held less than half the proportion of EM stocks as in MSCI’s All Country World Index (10.5 per cent), according to data from Goldman Sachs.

“Emerging markets traditionally do provide some good diversification for portfolios and that aspect is returning,” says Avo Ora, head of EM Equities at Pictet Asset Management.

© Jamie Portch

EM equity indices have shown substantial growth this year, especially the Latin America and the Europe, Middle East and Africa regions. MSCI Latin America had leapt 31 per cent by August 12, ahead of the broader MSCI EM benchmark, and well ahead of most world markets.

But can it last? Higher GDP growth in the developing economies has not always translated into faster earnings growth deserving a premium valuation. This explains why EM equities trade at a substantial one-third valuation discount to world markets, when using forward price to earnings ratios.

The dollar’s dip has helped paint a rosier picture. Earnings per share estimated growth for the 1,202 companies in the dollar-based MSCI EM benchmark now exceeds that for the world index. Over the coming two years the EPS growth rate is expected to compound at over 13 per cent annually. That’s faster than the world index’s rate of 9.6 per cent.

Naysayers on emerging markets might point to the gap in profitability between EM and DM-listed companies. Using MSCI data, return on equity remains significantly lower in EM at around 13 per cent compared with the 17 per cent seen in the developed markets. US equities have an even higher return on equity.

Blame “a failure to weed out the weaker, family-run companies,” says Manik Narain, head of emerging markets strategy at broker UBS. Shares of connected companies in South Korea with family ties (conglomerates known as chaebol) have long received lower valuations. He adds that India has had the same market structure for more than a decade and not much has changed in terms of company rankings.

Corporate profitability could improve in the years ahead. An effort to force better corporate governance in some markets, including South Korea and China, could make a difference to otherwise sluggish companies deaf to shareholder concerns. Any future monetary easing in markets, such as Brazil and Indonesia, could also help. “Real rates are just too high relative to where they should be in terms of inflation [trends],” adds Narain at UBS.

Another issue to contend with if investing in EM equities is that most funds have no choice but to tilt their portfolios towards emerging Asian markets, as the benchmark has a high concentration in that region. As of July 31, over 76 per cent of the MSCI index benchmark was in four markets: China, Taiwan, India and South Korea. One company, Taiwan Semiconductor Manufacturing, represents over a tenth of the index itself.

That presents a problem for fund managers which have portfolio weighting limits. A Ucits fund, for example, cannot hold more than 10 per cent in one asset.

EM equity managers do their best to cope. “Right now we are underweight Asia and overweight LatAm,” says Naomi Waistell, an EM portfolio manager at Carmignac, an asset manager. She thinks Latin American markets offer better value and that the high real rates there will fall. “Buying the index [via a low fee ETF] is backward looking.”

Just owning the index via an ETF can mean the investor has little choice but to own an Asian fund, thinks Waistell. Active managers have more room to emphasise other regions.

Andrew Ness, portfolio manager of Templeton Emerging Markets Investment Trust, also tries not to worry about market weightings. His team seeks companies with growth potential where the business trades below its intrinsic value, regardless of index inclusion.

But the potential from currency gains offers a boost. “EM currencies look cheap on a real effective exchange rate basis,” says Ness. This model values a currency against others using relative inflation differentials.

His London-listed investment trust trades at a 9 per cent discount to its net asset value, offering an extra kicker to performance when the underlying assets rally in price. Since the end of 2024, the share price has outrun the fund’s net asset value squeezing the discount down from 14 per cent. It has the largest global EM equity trust by market value, followed by those from JPMorgan and Fidelity.

There may have been many false starts for emerging markets in the past decade. However, given the fiscal dominance threat in the world’s largest economies, an erosion of trust in the US dollar and the yawning valuation gaps between US stocks and their international counterparts, there is a decent chance this year’s rally will continue.

Maybe it really is different this time.