Emerging markets are an AI play at a huge discount, says HSBC's Alastair Pinder

Key Concepts

• Emerging Markets (EM) Equity: Stocks of companies in developing countries.
• AI Play: Investment strategy focused on companies involved in Artificial Intelligence.
• Discount: Investing in assets that are undervalued relative to their intrinsic worth.
• Ownership/Crowding: High concentration of investors in specific stocks or sectors.
• Capex (Capital Expenditure): Funds used by a company to acquire, upgrade, and maintain physical assets.
• Mag 7: Refers to the seven largest technology companies in the US (Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia, and Tesla).
• Dollar Weakening: A decrease in the value of the US dollar relative to other currencies.
• New Economy Sectors: Industries like technology, semiconductors, and electric vehicles (EVs).
• EM Index: A benchmark representing the performance of emerging market equities.
• Infrastructure Spending: Government or private investment in public works and facilities.
• Valuation Rerating: An increase in the market's perception of a company's or market's worth, leading to higher price-to-earnings ratios or other valuation multiples.
• Monetary Stimulus: Actions by central banks to increase the money supply and lower interest rates.
• Fiscal Stimulus: Government spending or tax cuts to boost economic activity.
• Interest Rates: The cost of borrowing money.
• Bond Yields: The return an investor realizes on a bond.
• Tariffs: Taxes imposed on imported goods.
• Trade Deals: Agreements between countries to reduce or eliminate trade barriers.
• USMCA (United States-Mexico-Canada Agreement): A trade agreement between the three North American countries.

International Equity Markets: A Shift Towards Emerging Markets and Beyond

Record Highs and Underperformance

While US markets have reached record highs this year, they are significantly underperforming emerging market (EM) indices. Oppenheimer data indicates that the largest percentage of global stock indices are at all-time highs in 26 years, including the NIK (Japan), Korea's KOSPI, the STOXX Europe 600, Germany's DAX, Brazil's Bovespa, and Egypt's EGX30. This raises the question of whether investors should diversify outside the US as the new year approaches.

The AI Thesis in Emerging Markets

Alistair Pinder, HSBC Head of Emerging Markets and Global Equity Strategist, highlights that a primary thesis for investing in emerging markets is that they represent an "AI play at a huge discount." Unlike the crowded AI stocks in the US, EM offers exposure to AI-related sectors at a lower valuation and with less investor concentration. This is particularly true for Asia, including China, Korea, and Taiwan. Pinder emphasizes that these EM companies have not undertaken the same extensive capital expenditures (capex) as the "Mag 7" in the US, reducing concerns about return on investment for their AI initiatives.

Currency Tailwinds and Dollar Weakness

The strengthening US dollar has been a supportive factor for international equity markets this year. However, Pinder anticipates a fundamental weakening of the dollar going into next year. This projected dollar depreciation is seen as a further catalyst supporting the case for emerging market equities and even European equities.

Sectoral Shifts in Emerging Markets

The composition of EM indices has undergone a significant transformation. "New economy sectors," encompassing technology, semiconductors, and electric vehicles (EVs), which previously accounted for only 15% of the EM index, now represent nearly 40%. This shift is predominantly driven by EM Asia, aligning with the AI investment theme.

Germany: A Standout in Europe

In Europe, Germany is identified as a clear winner for international equity rotation. The country is undertaking substantial infrastructure spending, which is expected to continue into the next year. Pinder believes this growth potential is not yet fully priced into German equities, noting that outflows from Germany and a slight derating in valuations present an opportunity for significant growth upside.

LatAm and EMIA: The Stimulus and Valuation Rerating Story

Markets that have performed well this year have often benefited from stimulus, whether monetary or fiscal. Mexico, which recently cut rates again, serves as a prime example. For EM Asia (EMIA) and Latin America (LATAM), including Mexico and Brazil, the key story is the presence of extremely elevated interest rates (above 7% in Mexico, 15% in Brazil, and around 10% bond yields in South Africa). These countries have room for interest rate cuts, which are expected to support valuations. Pinder argues that this potential for a "valuation rerating" in LATAM and EMIA is a crucial, and currently underpriced, theme for the upcoming year, even if the earnings growth story might not be the most exciting.

Tariffs and Trade Policies: A Surprising Catalyst

Contrary to expectations, tariffs have, in a peculiar way, benefited international markets. Pinder suggests that stimulus measures in countries like China and Germany were implemented to offset the impact of tariffs. Furthermore, the uncertainty surrounding tariffs is beginning to dissipate, with concerns about their impact on exports proving less significant than initially feared. The emergence of trade deals, such as Trump's tour of Asia and potential for a USMCA deal next year, are viewed as positive catalysts for international markets.

Conclusion

The current market landscape suggests a compelling case for diversifying beyond the US. Emerging markets, particularly in Asia, offer an attractive "AI play" at a discount, supported by a shift towards new economy sectors and a weakening US dollar. Germany presents a strong opportunity due to its infrastructure spending and undervalued equities. Latin America and EMIA are poised for a valuation rerating driven by anticipated interest rate cuts. Moreover, a reduction in tariff uncertainty and the prospect of new trade deals further bolster the outlook for international equities.