The phrase “Do you want the good news or the bad news first?” is used often, and according to my own preference I will start with the bad news for those invested in global emerging markets. Over the past 10 years, emerging market equities have underperformed their development market counterparts by a wide margin. In fact, over the ten-year period to the end of September 2022, the MSCI EM index return of +2.4% pales in comparison to the MSCI World and S&P 500 indices, which returned +10.1% per annum and +13.2% per annum respectively.
Now that we have ripped off the band-aid (oops!), the most important question to ask from an investment perspective is: Does it make sense to invest in EM equities today and what can we expect in terms of future returns?
In this brief article, we outline some of the key reasons why we believe investing in EM equities still makes sense, and why we believe it is more important than ever for investors to take a proactive approach.
Reason 1: Compelling valuations
For many of us, this is the most challenging market environment we have faced in our working lives: soaring inflation, the conflict in Europe and the cost-of-living crisis caused by soaring energy prices. These events are not unprecedented, but they have not affected us for a significant period of time, let alone simultaneously. Against the backdrop of market chaos, it is difficult to step back and think about the fundamentals. However, let’s digress and do so, and given that an investor’s entry point ultimately determines how profitable a trade will turn out to be, there is no better place to start than with valuations.
It’s hard to believe that emerging market equities once traded at a significant premium to developed markets, but that’s exactly what happened at the end of the commodity super-cycle in 2000-2011. That premium has since evaporated, and this asset class now trades at a 44% discount to developed-country equities based on Shiller P/E, a cyclically-adjusted price-to-earnings ratio that adjusts ten-year earnings for inflation. While the Shiller P/E has no predictive power for short-term returns, this ratio can be a powerful indicator of long-term returns and therefore should not be ignored.
Reason 2: Rising income and GDP growth in Asia
EM equities represent attractive value on a relative basis for a very good reason. In general, EM corporate earnings growth has been much weaker compared to developed market corporates. For example, earnings growth for the MSCI Asia ex Japan Index has declined from 13% in 2000-2010 to 7% in 2011-2021. This raises the question: What will happen to earnings in the future and what impact might this have on returns?
The earnings model developed by Goldman Sachs, which analyses sector fundamentals and country macro data, suggests that earnings growth in Asia could increase by up to 10% per annum over the next five years. This represents a significant increase in earnings over the 2011-2021 period, which could trigger a period of rising Asian equity values, which in turn would lift global emerging markets.
In favour of this potential increase in corporate earnings is the projected difference between real GDP growth in emerging and developed markets. While this differential is estimated to fall below 1% in 2022, it is expected to increase significantly in 2023. JP Morgan estimates that real GDP growth in emerging markets could be 3.2% in 2023 compared to 0.9% in developed markets. The widening of the growth gap comes at the expense of China and developed Asia, where growth of 4.6% and 4.1% is expected in 2023, respectively.
Reason 3: Moving out of favour would mean a significant inflow of capital
Finally, emerging market equities are currently under-represented in the average investor’s portfolio. According to JP Morgan, global investors currently allocate 6.4% to emerging market equities, well below the 20-year average of 8.9%. A change in sentiment and a return to this long-term average would mean an inflow of almost $750 billion. Investors who have moved to a neutral or overweight position in EM equities ahead of the herd would obviously benefit more if such a reversal in sentiment were to occur.
Conclusion
Emerging market equity investors have had a difficult decade. However, as investors, we must look ahead, and there is reason to believe that a brighter next chapter awaits this asset class. Relative valuations look attractive and earnings in Asia have the potential to recover, while GDP growth will be much faster than in the developed world. Given these factors, and the fact that emerging market equities are currently underweight in the average investor’s portfolio, we believe emerging market equities are on the road to recovery, and any further short-term pain will be outweighed by the possibility of longer-term gains.
