A return to emerging markets

Exceptional earnings growth even as valuations remain well below those in the U.S.

Higher global rates are raising the hurdle for returns, but they have not knocked us off our pro-risk stance. Higher rates and strong equities need not be contradictory – what drives yields matters. When higher yields reflect stronger investment and growth, the resulting earnings strength can help offset a higher cost of capital. That explains why we maintain our U.S. equity and AI overweights. Our return to an overweight in emerging market (EM) equities offers another way to invest in the AI scarcity theme.

The bar for taking risk is rising as rates reset higher, making the durability of earnings more important. We think AI-related investment can support growth and profits even as the same investment boom absorbs capital, power, and other scarce resources. EM equities now offer another place where earnings can clear that higher hurdle. The fundamental case has strengthened: Earnings growth is exceptional even as valuations remain well below those in the U.S. (see the chart below).

The tactical backdrop has improved too. We closed our previous overweight in EM equities in our Midyear Outlook in June as leverage concerns built, particularly in Korea. Korean equities subsequently experienced losses, and summer deleveraging has since eased those leverage concerns, supporting our return to overweight.

A return to EM equities

The numbers reinforce the case for returning to EM equities. Consensus expects headline earnings per share for the MSCI Emerging Markets Index to grow over 34% over the next 12 months versus about 20% for the MSCI USA Index. Yet EM equities trade at only 10 times forward earnings versus nearly 20 times for their U.S. counterparts. That is a 50% discount, with the EM multiple in the bottom 10% of its 20-year history.

A weaker U.S. dollar could add support by easing financial conditions, supporting local currencies, and encouraging foreign capital inflows. But our view does not depend on it. We see dollar weakness and stronger inflows as additional support rather than the foundation of our EM call.

The headline EM rally masks very different sources of returns, but AI scarcity is one thread connecting them. South Korea and Taiwan sit at the heart of semiconductor, memory, and hardware supply chains. Latin America, including Brazil, offers exposure to the resources and physical infrastructure needed for the AI buildout. These are different expressions of the AI scarcity theme that is an important part of our U.S. equity overweight. That overlap is deliberate and concentrates some of our equity exposure to the AI buildout. Over time, cheaper models and greater commoditization could shift where AI profits accrue. We therefore prefer to stay selective and dynamic rather than assume today’s winners will remain tomorrow’s.

Investment implications

We remain pro-risk but see little room for complacency. We maintain our U.S. equity and AI overweights, return to an overweight in EM equities, and downgrade short-term European government bonds to neutral.

Two risks could challenge that stance. First, markets have absorbed the Middle East shock well, but Strait of Hormuz traffic remains severely constrained, and scarcity has shifted downstream into refined products. Renewed energy pressure could keep inflation elevated just as the Fed faces a difficult policy choice. A hold despite persistent inflation and a tight labor market could test its credibility, with the term premium acting as a release valve as investors demand more compensation to hold long-term bonds. That could push long-end yields higher and raise the hurdle for equity returns. We stand ready to adjust as conditions change. [The Fed raised its target range for the federal funds rate by 25 basis points, to 3.75%-4.00%, on Sept. 16. – Ed.]

Bottom line: Strong fundamentals keep us pro-risk despite higher rates. Exceptional earnings growth, attractive valuations, and a cleaner tactical backdrop support our U.S. and AI overweights and a return to an overweight in EM equities. But this is not an unqualified bullish call. A lot can still go wrong, and we stand ready to shift from risk-on if the signposts change.

Wei Li, Managing Director, is the Global Chief Investment Strategist at BlackRock Investment Institute at BlackRock Inc.

Beata Harasim, Senior Investment Strategist – BlackRock Investment Institute, Michel Dilmanian, Portfolio Strategist – BlackRock Investment Institute, and Sam Vecht, Portfolio Manager, Global Emerging Market Equities – BlackRock, contributed to this article.

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