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: Year-to-date, the MSCI EM index has nearly caught up with the S&P 500®. Many Asian countries were better able to contain the virus, enabling their economies to reopen more fully. Still, bottom up analyst earnings estimates suggest a more robust earnings recovery for the emerging market index in 2021 and 2022. That combined with lower relative valuations should allow for outperformance going forward.
- 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 16x versus 31x for the S&P 500® (as of November 30, 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 November 2020
|Price/Trailing 10 Year EPS||1|
|Summary Signal (Average)||2.2|
*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.
- We had anticipated a reversal in capital outflows as pandemic fears eased, and that has begun to happen. November saw one of the biggest inflows of capital into emerging markets on record. Capital inflows can help spur economic growth, creating a positive backdrop for earnings.
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 strengthen 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 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 (November 2020)
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