After a decade of perceived hibernation and as spring arrives, emerging markets (EMs) may finally be awakening from their slumber, and a number of “green shoots” are beginning to emerge. Without question, past performance has proven to be a challenge relative to U.S. equities – the S&P 500® has been the strongest game in town over the last 10 years. So what do we expect could change for investors?
EMs encountered multiple macroeconomic headwinds over the last 10 years, including multiple developed market recessions, an oil price crash, a Federal Reserve on autopilot at times, dollar strength, and global trade tensions.
From that perspective, we find it quite remarkable that EM equities showed points of strength at any time in the previous 10 years, let alone managed to outperform the MSCI World ex-USA Index over the whole period on a total return basis.
In the second-quarter 2019 Strategy Insights, we explore the ever-evolving world of EM equities, outlining their key defining characteristics, what role we expect EMs to play in investment portfolios, and why we may be approaching an opportune time to add to existing positions or initiate new ones.
The term “emerging markets” may still conjure up images of investing in third-world banana republics. Quite to the contrary, we believe EMs represent the global economic growth engine, making significant strides in technological innovation supported by the emergence of a growing middle class.
EM countries, infrastructures, and economies vary, resulting in a fairly heterogeneous asset class. However, they all tend to be classified in a “high growth phase” characterized by rapidly expanding and improving market environments, as measured by key factors such as macroeconomic conditions, higher absolute levels of GDP growth, greater relative political stability to frontier markets, developing capital market processes, and financial market trading and settlement procedures.
The Strategic View
We recognize long-term structural changes in China and other emerging economies such as India are still underway. However, many EM countries are going through transformational shifts, including a massive swing away from heavy industry models to more consumption-oriented economies.
Over time, the growing technology-focused consumers in these economies will likely become significantly important not only to their local markets but also to the global economy.
We believe longer-term trends in developing/emerging countries look both sustainable and investable and should, over time, continue to result in stronger-than-average growth tailwinds relative to the developed world.
The Tactical View
1. Business Cycle Analysis
The first and perhaps most important component of our investment process is our analysis of the business cycle, given its strong influence over tactical (one- to two-year) investment performance. As we examine what stage of the business cycle we are in, the attractiveness of different parts of the investable universe becomes more apparent. A more constructive cyclical backdrop appears to be developing in EMs: signs of an acceleration in Chinese credit growth, the pause in U.S. interest rate hikes, stabilization of EM currencies versus the dollar, apparent progress between the United States and China on trade relations, and the rebound in energy and commodity prices.
In combination, we think these favorable developments could lead to a spring thaw and ultimately re-rating of EM equity valuations in the form of relative outperformance versus developed market equity asset classes.
2. Valuation Methodology
The second component of our investment process is an in-depth examination of global valuations. Once we have identified the current phase of the business cycle, our valuation work tells us about the long-term return potential of an asset class versus its own historical return profile and compared to other competing asset classes.
Despite exhibiting a substantial relative valuation discount, the EM forward price/earnings multiple is slightly above its historical average on an absolute basis. However, this seems intuitive to us. Sectors with traditionally lower valuation multiples, such as Energy and Materials, have seen their weightings dramatically reduced in the EM Index, putting upward pressure on forward earnings multiples simply due to index composition shifts over time.
The valuation story has become increasingly compelling, presenting an opportunity to capture additional exposure to these cyclical and secular growth trends at a marked discount to other equity markets.
3. Technical Analysis
The third component of our investment process focuses on technical analysis, which helps forecast the direction of security prices through a study of past market trends. There is a distinction between market timing and using technical analysis for the appropriate time to move in or out of an investment (that is, when is the right time to not fight the market on entry). The technicals help us identify what those forces might be and if the tide might be turning.
Although the technical backdrop for the MSCI EM Index had been looking quite weak, particularly over the latter half of 2018, we have started to see a stabilization and perhaps the early innings of a sustainable rally. The index pushed through the 200-day moving average in early 2019 and has now become the new support level, suggesting to us a continuation of current trends is possible.
EM as an asset class is neither homogeneous nor efficient. On a rolling three-year basis, at no time has the MSCI EM Index ranked in the top quartile of the EM peer universe. Yet over the last 10 years, the EM Index has beaten the S&P 500 roughly 40% of the time. In other words, the heterogeneous dynamics of the EM universe of stocks, coupled with relatively low correlation with the S&P 500, suggest to us EM active management not only has the potential to enhance diversification relative to the so-called “China complex” (combination of China, Taiwan, and Hong Kong) weighting of the index but also has shown the ability to generate meaningful alpha for investors.
Therefore, our preferred method of accessing exposure to EM equities is not via an index tracker but rather through the use of a complementary pair of high active share, lower turnover, and fairly concentrated active managers. An example could be pairing an active EM equity manager that is overweight consumer and internet-based exposures with a manager focused on higher quality financials and commodity-based industries and companies. Taking it a step further would be looking for managers with experience in specific countries or regions rather than EM generalists. Also, for those investors interested in pursuing a responsible investing-oriented strategy in EM, there are both actively managed and passive solutions.