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 11% 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 underweight for EM exposure due to concerns surrounding U.S. monetary policy tightening taking liquidity out of the marketplace and concerns about China’s growth potential amid property sector difficulties and zero-tolerance COVID policy. China has been taking modest steps to stimulate the economy, but many other emerging countries are raising interest rates to combat inflation. EM relative valuation remains the current positive, and the monetary pressure could start to alleviate next year.
- 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 13.5x versus 30.4x for the S&P 500® Index (as of August 31, 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 as there are many cross currents. China is the largest weight in the Index representing approximately 30%. China’s clampdown on the property sector and its COVID-zero tolerance policy have dimmed its growth prospects. Local currency earnings estimates have fallen 19% year-to-date. Estimates for the next three largest weights (India, Taiwan, Korea) are more mixed. Overall, EM estimates have fallen about 10% in local currency terms. Visibility into 2023 is low, but with estimates already down, EM appears more reasonable, at least directionally, than the S&P 500® Index where estimates imply earnings growth.
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. Secondarily, Emerging Markets 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.
- 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 Perspective
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.
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.
This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.
Please consider the investment objectives, risks, charges and expenses of the fund carefully before investing. The prospectus and the summary prospectus contain this and other information about the Fund. To obtain a prospectus or a summary prospectus, contact your financial professional or download and/or request one on the resources section or call Touchstone at 800-638-8194. Please read the prospectus and/or summary prospectus carefully before investing.
Not FDIC Insured | No Bank Guarantee | May Lose Value