Emerging market equities have suffered another decade of underperformance versus developed markets. Recently, their underperformance has been more marked relative to US markets than the rest of the world. With sentiment having already brightened in developed markets as the COVID-19 lockdowns are eased, and valuations, particularly in the technology sector, having become elevated, this may be a good time to rotate into EM equities.
In the near term, the commodity-sensitive Latin America and EMEA regions should outperform as crude oil and metal prices continue to recover, while equity markets in China may lag due to US election-related political tensions.
Over the medium term, however, the effects of China’s large fiscal boost to the economy should feed through to the rest of the region and the dominance of Asia, and in particular of Chinese technology, should reassert itself.
The long and short of it
The long-term drivers of emerging market equity outperformance are well known:
- leapfrogging developed market technology
- piggybacking on DM research & development
- faster productivity growth
- better demographics
- rising labour market participation.
While these are all generally true, the market has moved to its own rhythms. Since 1975, periods of EM outperformance and underperformance have cycled over roughly 10-year spans, with the latest wave of underperformance beginning in 2010.
The most recent period is unique, however, in that since 2013, the underperformance of EM has been largely against the US, while against the rest of developed market equities, returns have been in line.
Performance divergence is mainly due to tech stocks
As with so many markets these days, the technology sector explains much, though not all, of the divergence in performance. Emerging markets have underperformed the US in most sectors, including
- information technology
- consumer discretionary (recall, this sector includes the world’s largest internet store)
Compared to developed market equities excluding the US, the lagging sectors are similar with the significant exception of IT. Given the low weight of tech in the MSCI World ex-US index, the outperformance of emerging markets tech easily offsets the losses in the other sectors, leading to a flat performance overall (see Exhibit 1).
Could we be at another turning point in emerging market equity performance?
At least in the near term, there are reasons to believe this may be the case. Developed countries have largely passed through the worst of the coronavirus pandemic and are in the process of managing their exit from lockdowns. While we expect one, or several, second waves, it is unlikely nationwide restrictions will be imposed to the same degree. One reason is that the economic cost may be prohibitive.
Also, with the knowledge gained over the last several months about the effects of the virus, we now know that vulnerable populations (notably those over 55, who have accounted for 93% of deaths in the US), can be protected without having to confine children and a vast share of the working age population.
Developed market equity performance has also ready reflected this comparatively more optimistic outlook, however, since March. By contrast, many emerging markets are either still in some stage of lockdown or only slowly exiting them, often unwillingly, and the economic rebound has yet to occur.
Another reason for optimism is the outsized fiscal and monetary stimulus in China, which is nearly on par with the stimulus in 2015-2016. If history is any guide, this support should not only benefit the Chinese economy, but also other emerging markets, though in 2015-2016, it took several months before the relative performance of the markets reflected the impact (see Exhibit 2).
Valuations are a further factor in favour of emerging markets. The price-book ratio of the MSCI EM index relative to that of the MSCI World index is near the lows since 2003. For the IT sector, relative multiples have rarely been this low since the tech bubble in the late 1990s.
On a price-to-next-twelve-month (NTM) earnings basis, relative multiples are similarly near levels not often seen since 2005 after which there was an extended period of EM outperformance.
What are the risks?
Ahead of November’s US presidential election, it is reasonable to expect heightened anti-China and anti-trade rhetoric from President Donald Trump. During the worst of the trade war, emerging markets and particularly China underperformed the US. That said, the political calculation could also support at least another interim resolution as a rising stock market could still be one of Trump’s strongest claims to re-election.
The economic rebound in emerging markets ex-China may not be as strong as that in the developed world as most emerging markets do not have the same capacity for fiscal or monetary stimulus.
The collapse of many EM currencies, while helping exporters, will pose a problem for companies with significant hard currency debts.
Moreover, weaker currencies will be of less benefit to exporters when global trade is likely to remain subdued and many developed countries wish to re-shore production.
We will address some of these nuances in the part two.