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: The MSCI Emerging Market Index performed in line with the S&P 500® Index in 2020 and has underperformed year-to-date in 2021. Meanwhile, EM earnings have been outpacing the S&P 500® year-to-date, but slowing in China’s economy and a number of EM central bank moves to hike rates have halted further gains. Earnings growth expectations have moved down for EM, but this means they look much more achievable than expectations for the S&P 500®. That, and relative valuation, may still give EM a performance edge.
- Emerging Markets (EM) have historically experienced significant price swings, creating large valuation peaks and valleys. Currently, the MSCI Emerging Market index looks attractive relative to the S&P 500® Index and has become more attractive throughout the pandemic. This has mostly been a function of the U.S. market getting ahead of the fundamentals. On a price-to-trailing-10-year-earnings basis, which smooths earnings cycles, the MSCI Emerging Market Index traded at 18x versus 39x for the S&P 500® Index (as of August 31, 2021). However, the MSCI Emerging Markets Index is still not that cheap relative to its own history.
- The previous valuation lows occurred during the Asian Financial Crisis. Since that crisis, corrective action has taken place across many EM 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 downturn.
Relative Valuation Measures
Based on the MSCI Emerging Markets Index/S&P 500® Index as of August 2021
|Price/Trailing 10 Year EPS||1|
|Summary Signal (Average)||1|
*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. Though, compositional changes to the Index explain much of this underperformance (not fundamentals), changes that are unlikely to be repeated.
- The spread of the Delta variant in Asia has slowed growth in significant EM economies. China’s zero tolerance policy toward the pandemic could also postpone its ability to fully recover. Additionally, a number of Latin American countries have raised rates to manage inflation, which could dampen their recoveries. All of these factors have halted an upward shift in earnings estimates unlike the S&P 500®. While visibility remains low, it appears the relative earnings momentum has begun to shift towards the U.S.
Sources: Bloomberg, Bloomberg Consensus Estimates, MSCI
Trend in EM Currency
- The MSCI Emerging Markets Index is quoted in U.S. Dollars (USD). As such currency shifts between the USD and Emerging Markets (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 though, a rise in longer term U.S. Treasury yields may temporarily inhibit further gains in EM currencies.
*Normalization adjusts or rescales the values of different time series to a notionally common scale to allow for comparability.
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 2021)
Emerging Markets Perspective
One of the biggest growth opportunities for emerging markets relates to the smartphone. It is not the smartphone itself, but all the applications and industries that come along with it. Just think about when the automobile became ubiquitous and all the industries it created that didn’t exist prior—from highways to gas stations, fast food chains, housing (suburbs), billboards, motels, and many other businesses not directly associated with making cars. The smartphone is having a similar impact and it remains an underpenetrated market in emerging markets. This is just getting started. The following chart creates perspective on not just the penetration, but also the sheer size of the emerging markets. Another factor to consider when looking at this chart is that a user is not an owner. It is not unusual for a whole family in an emerging market to share one smartphone, but each family member will still be counted as a separate user. As such these penetration rates likely overstate the true level of market penetration.
Sources: World Bank, DataReportal, VentureBeat, Juniper Research, SPMP Research, Pew Research
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