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 11% of global equity market capitalization (Source: MSCI), yet their economies represent approximately 40% of global GDP (Source: International Monetary Fund).
But why now?
Conclusion: Emerging Markets have struggled relative to the S&P 500® in 2019. Much of the underperformance can be attributed to relative earnings underperformance, due to direct and indirect pressures from the tariff war between the U.S. and China. Up until August, we had been operating under the assumption that some sort of trade resolution was reached, which would take the pressure off emerging markets earnings. The escalation in the tariff war in August led to a reassessment of this assumption. We have now adopted a more pragmatic posture that the tariff war is likely to extend into 2020 and that emerging markets earnings will remain under pressure.
Our views on Emerging Markets Equities are based on historical relative valuations vs. the S&P 500 Index, relative earnings prospects vs. the S&P 500 Index, trends in emerging markets currency, and growth of the middle class.
- Emerging Markets have historically experienced significant price swings, creating large valuation peaks and valleys. Relative to the S&P 500®, Emerging Markets look attractive. On a relative Price/Book basis and on a relative Price/Sales basis, the EM index is selling below 80% of the historic observations.
- 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 suggesting that those valuation extremes may not be revisited.
- On a price-to-trailing-10-year-earnings basis, which smooths earnings cycles, the MSCI Emerging Market Index traded at 13x versus 28x for the S&P 500® (as of August 31, 2019).
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 been working from an assumption that President Trump and President Xi would reach a trade compromise that would ease pressures on emerging markets earnings. Given August’s escalation in tariffs and posturing that indicates less flexibility by either side, we have abandoned our expectation of an impending trade agreement. Certainly the situation remains fluid and could change at the drop of a tweet. But at this point, we believe it is prudent to adopt a more cautious stance. This leads us to a less optimistic outlook for relative emerging markets earnings prospects.
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 and potential economic slowing as local interest rates may need to rise to support local currencies. 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. The near-term picture, though, has grown more mixed. An escalation in the tariff war has been offset by signs of weaker U.S. economic growth. That has created expectations that the U.S. Fed will continue to ease monetary policy.
*Normalization adjusts or rescales the values of different time series to a notionally common scale to allow for comparability.
Emerging Markets Middle Class Growth
- Looking back, the Emerging Markets story has been one that has mainly surrounded the massive industrialization and urbanization of China. Looking forward, we see the story expanding beyond China as high manufacturing wages push labor intensive, low margin factory production out of China and into other emerging markets. This process allows the labor force in other emerging markets to enter the middle class. We are seeing evidence that the U.S. tariff war with China is accelerating this process with numerous countries benefiting, including India, Vietnam, and Mexico.
- As can be seen in the chart below, we are in the very early stages of this trend. Middle class growth in Emerging Markets is expected to exceed 6% annually versus less than 1% for the developed markets (Source: Brookings).
- Brookings estimates that total middle class spending will increase from $35 trillion in 2016 to $64 trillion in 2030 with over 80% of the incremental spending coming from Emerging Markets. This implies a sum total of $174 trillion to be spent over that period by emerging middle class consumers assuming a straight line progression from a $35 trillion annual rate to $64 trillion.
Source: OECD – The Emerging Middle Class in Developing Countries
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 2019)
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