Emerging Markets vs. U.S.
We believe equity investors should consider Emerging Market (EM) stock exposure due to the following more secular qualities:
- Diversification: portfolios that included Emerging Market stocks have historically produced higher risk-adjusted returns (Bouslama and Ouda).
- Relative Economic Growth: Emerging Markets are expected to account for 70% of global economic growth through 2025 with middle class spending growth being the main driver (McKinsey & Co).
- Growing Middle Class: by 2025 Emerging Market consumption will represent approximately half of global consumption (McKinsey & Co).
- Equity Market Expansion: Emerging Market equities represent only 12% of global equity market capitalization (Source: MSCI), yet their economies represent approximately 41% of global GDP (Source: International Monetary Fund).
But why now…?
Conclusion: We had anticipated that the phase one trade deal would alleviate the earnings pressure for China, but building acrimony on other fronts with China may prevent this. China represents approximately 39% of the MSCI EM index making it an important index driver. The COVID crisis is likely to accelerate the offshoring trend that was already in place. While a negative for China, this trend is likely to benefit other emerging markets. We continue to be attracted to the growing emerging markets, and like the valuations, but believe a selective approach is warranted given numerous cross-currents.
- Emerging Markets have historically experienced significant price swings, creating large valuation peaks and valleys. Relative to the S&P 500®, Emerging Markets still look attractive, though most measures are distorted as a much larger drop in EM sales, earnings, and cash flow due to the more cyclical nature of EM are having a distortionary impact on these relative valuation measures. On a price-to-trailing-10-year-earnings basis, which smooths earnings cycles, the MSCI Emerging Market Index traded at 14.6x versus 31x for the S&P 500® (as of August 31, 2020).
- The previous valuation lows occurred during the Asian Financial Crisis. Since that crisis, corrective action has taken place across many Emerging Market countries in both the public and private sectors. These actions included stronger regulations, fiscal policy, and capital controls. These measures helped prevent a major EM crisis from forming during the current downturn.
Relative Valuation Measures
Based on the MSCI Emerging Markets Index/S&P 500® Index as of August 2020
|Price/Trailing 10 Year EPS||3|
|Summary Signal (Average)||2.6|
*Average of the five relative valuation measures.
Sources: Bloomberg, MSCI
Relative Earnings Prospects
- Relative price performance and relative earnings growth have historically followed similar paths. S&P 500® Index earnings have been outpacing MSCI Emerging Markets Index earnings since 2008, helping explain S&P 500® Index outperformance. China was a positive contributor to EM earnings over the last cycle, however, we believe China could become an earnings headwind in the next cycle, hampering earnings growth for the index.
- Capital flows into emerging markets have declined dramatically year-to-date creating a headwind for economic and earnings growth. As the COVID crisis wains we see the potential for increased capital flows, though the deteriorating relationship between China and many developed countries may lead to some bifurcation in those flows. Historically China was the biggest beneficiary of capital flows.
Sources: Bloomberg, Bloomberg Consensus Estimates, MSCI
Trend in EM Currency
- The MSCI EM Index is quoted in U.S. Dollars (USD). As such currency shifts between the USD and EM currencies will impact returns directly. Secondarily, EM economies can be negatively influenced when the USD rises due to the higher interest burden on debt issued in USD. That said, a freely floating currency may act as a steam valve that over time self regulates the economic impact. The degree of economic impact differs by country and is mostly dependent upon how much debt is issued in USD and the importance of external trade with other countries.
- Currency analysis is highly complex with short-term, medium-term, and long-term drivers on both sides of the ledger. In general, the medium-term and long-term drivers favor EM currencies over the USD. In the near-term, we believe EM currencies are likely to rise as/when the COVID crisis eases.
*Normalization adjusts or rescales the values of different time series to a notionally common scale to allow for comparability.
Emerging Markets Middle Class Growth
- Looking back, the Emerging Markets story has been one that has mainly surrounded the massive industrialization and urbanization of China. Looking forward, we see the story expanding beyond China as high manufacturing wages push labor intensive, low margin factory production out of China and into other emerging markets. This process allows the labor force in other emerging markets to enter the middle class. We are seeing evidence that the U.S. tariff war with China is accelerating this process with numerous countries benefiting, including India, Vietnam, and Mexico.
- As can be seen in the chart below, we are in the very early stages of this trend. Middle class growth in Emerging Markets is expected to exceed 6% annually versus less than 1% for the developed markets (Source: Brookings).*
- Brookings* estimates that total middle class spending will increase from $35 trillion in 2016 to $64 trillion in 2030 with over 80% of the incremental spending coming from Emerging Markets. This implies a sum total of $174 trillion to be spent over that period by emerging middle class consumers assuming a straight line progression from a $35 trillion annual rate to $64 trillion.
*These estimates predate the COVID-19 outbreak, which has reversed these middle class growth trends.
At this time, we believe this is a temporary interruption in a long-term positive trend.
Source: OECD – The Emerging Middle Class in Developing Countries
Emerging Markets Perspective
Emerging Markets equities are under represented in a global context given their relative size by other measures.
Sources: *International Monetary Fund (IMF) (2017), **MSCI (August 2020)
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