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 13% 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 slightly underperformed year-to-date in 2021. Meanwhile, earnings for the MSCI Emerging Market Index have outpaced the S&P 500® and analysts expect outperformance to accelerate as the global economy recovers. Relative earnings outperformance and lower relative valuations should potentially allow for EM outperformance going forward.
- 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 36x for the S&P 500® Index (as of May 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 current downturn.
Relative Valuation Measures
Based on the MSCI Emerging Markets Index/S&P 500® Index as of May 2021
|Price/Trailing 10 Year EPS||1|
|Summary Signal (Average)||1.2|
*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. While capital flows into Emerging Markets have slowed from the record reached in November 2020, they remain positive. 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 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 further 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 (February 2021)
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