Emerging markets are gradually finding favor with investors after bouncing back from tough times. The reasons underscoring the increase in investor appetite include improved prospects for global central banks' liquidity, the dovish shift in the Federal Reserve's strategy and signs of progress in trade negotiations between the U.S. and China. The rebound in equity and fixed income has somewhat closed the valuation gap, but not exhausted it. In fact, according to our forecasts, emerging markets equities and bonds are among the asset classes that should deliver the highest return potential for investors in the next five years, with performances in line or even above those experienced over the past five years.
However, while emerging markets assets face a brighter outlook, some areas of caution remain, notably on the geopolitical front with impending tariffs and upcoming elections. Investors' attitudes toward emerging markets are ever-changing and the ability to understand liquidity dynamics both at the macro and micro market level is key in assessing EM opportunities.
On the macro side, major developed market central banks are becoming extremely cautious to avoid excessive tightening of liquidity, given the potential for so-called quantitative tightening to disrupt markets and accelerate a recession. A more benign inflation outlook is also driving most of the emerging market central banks toward a more dovish stance.
Though the threat of excessive tightening in macro liquidity seems to be fading, thorough assessment of micro liquidity continues to be paramount. Micro liquidity is a multidimensional concept that typically refers to investor ability to execute large orders with limited price impact and is associated with immediacy and low cost of execution. This type of liquidity does depend on supply/demand dynamics, but ultimately is a proxy for risk-on or risk-off sentiment and investor confidence in the market's ability to secure trading. Hence, micro liquidity is highly relevant in a late phase of the cycle when market sentiment can switch rapidly to greed from fear, which in turn drives appetite for emerging markets assets.