Emerging Markets vs. U.S.
We believe equity investors should consider Emerging Market 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 13% of global equity market capitalization (Source: MSCI), yet their economies represent approximately 45% of global GDP (Source: International Monetary Fund).
But why now…?
Conclusion: We moved to an overweight for EM exposure after China signaled a shift to loosen its zero-COVID policy. While China still faces headwinds from its property sector and companies offshoring manufacturing, the release of pent-up consumer demand is likely to overwhelm. Valuations are attractive and EM countries in general are likely to see much better economic growth versus developed countries.
Valuation
- Emerging Markets have historically experienced significant price swings, creating large valuation peaks and valleys. Currently, the MSCI Emerging Markets Index looks attractive relative to the S&P 500® Index. On a price-to-trailing-10-year-earnings basis, which smooths earnings cycles, the MSCI Emerging Markets Index traded at 13.0x versus 30.7x for the S&P 500® Index (as of November 30, 2022). 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 Emerging Markets countries in both the public and private sectors. These actions included stronger regulations, fiscal policy, and capital controls. These measures helped prevent a major Emerging Markets crisis from forming during the pandemic-induced downturn.
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 EM Index explain much of this underperformance (not fundamentals), and they are unlikely to be repeated.
- It is hard to generalize EM as there are many cross currents. China is the largest weight in the Index representing approximately 30%. China’s leadership has created a path to an economic re-opening that turned us more positive on EM overall. The expected unleashing of pent-up demand is likely to trigger an upturn in China’s economy as well as the economies of its trading partners. EM earnings expectations have been revised significantly lower. We believe this sets EM up for possible upside surprises in 2023, something unlikely to occur for developed markets.
Trend in Emerging Markets Currency
- The MSCI Emerging Markets Index is quoted in U.S. dollars (USD). As such, currency shifts between the USD and Emerging Markets currencies will impact returns directly, though it is interesting to note that over the last 10 years, the dollar has been much less volatile versus EM than versus developed markets.
- While the USD has moved higher relative to developed country currencies, the move has been much more modest versus Emerging Markets. This is despite more hawkish signals from the Fed and the war in Ukraine. In the past, this type of stress would be more apparent in the Emerging Markets. That they have held up through the pandemic and now monetary tightening and inflation is suggestive of a generally more stable Emerging Markets landscape.
Emerging Markets equities are under-represented in a global context given their relative size by other measures.
In March, MSCI removed Russia from the Emerging Markets Index. This led to a significant drop in the number of companies in the Index and a more modest decline in the Index weight. We also adjusted the GDP and population estimates, using 2021 estimates from the IMF.
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 rates likely overstate the true level of market penetration.
Glossary of Investment Terms and Index Definitions
Ons Bouslama, Olfa Ben Ouda, International Portfolio Diversification Benefits: The Relevance of Emerging Markets, International Journal of Economics and Finance, 2014. McKinsey & Company, Winning the $30 trillion Decathlon – Going for gold in emerging markets, 2012.
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