Can Emerging Markets Continue To Shine?

Emerging market (EM) equities have been the best performing growth asset class in the past six months, beating the developed market (DM) index by around 10%. Is this the beginning of a reversal of EM fortunes after a decade of disappointment? In this note, we investigate the reason for the recent outperformance and outline why we think a meaningful exposure to EM over the long term makes sense for portfolios.

Around 5% of the outperformance is directly related to the weakening US$. However, there were more fundamental factors at play as well. China, Hong Kong, Taiwan and South Korea, countries with a substantial weight in the EM index, did not suffer a significant Autumn Covid wave (unlike the US and Europe) supporting their economies. The acceleration in credit growth in China also supported EM equities. There is a strong correlation between the relative performance of EM and DM equities and the Chinese credit cycle (see below).  EM equities have also benefited from having less growth/technology exposure than the DM index, which was hurt by the growth/value rotation in November.

Of the above list, the only feature which is potentially enduring is the growth/value rotation, a topic we have written about frequently this year. After falling around 10% in 2020, the US$ is now very close to its long run average value. A meaningful rebound in global growth will be needed to shift the currency significantly lower. EM Covid related outperformance will disappear next year with the vaccine roll out. Indeed, it may even go the other way given lack of vaccine supply in EM relative to DM. Chinese credit growth has also peaked. Long term interest rates and credit spreads have risen, increasing the cost of debt for Chinese corporates. The Government also allowed a few significant State-Owned Enterprises to default on their debt in recent months, which will tighten financing conditions further.

Now that the short-term outlook looks less attractive given positive catalysts for outperformance are fading, we also need to consider the fact that EM performance over the past decade has been underwhelming. A lack of US$ earnings growth over the period (despite strong domestic economic growth) has played a large part. The broad MSCI EM FX basket fell by around 30% between mid-2011 and early 2020. While there are certainly exceptions, from the general perspective of a foreign investor in EM businesses, a weaker currency is not desirable.

Following this decade of poor earnings growth, EM equities are trading at lower price to book multiple than in the beginning of 2010. The price to book multiple for DM equities has risen around 50% over the period. However, the combination of reasonable valuations and cheap currencies leaves EM equities with a good starting point for returns in the coming decade.

EM currencies should be supported in the decade ahead by capital inflows. Emerging markets are the only countries which now offer investors positive real interest rates. While EM interest rates have fallen alongside those in DM, there is still a meaningful spread of around 3½ percentage points on offer from an absolute perspective in these countries in aggregate. In a low yield world, this will encourage inflows. In addition, as China continues on its path to becoming the world’s largest economy, many investors will see an allocation to the Renminbi as a necessary portfolio diversification decision (alongside existing allocations to Euro, Pound and Yen).

We expect economic growth to continue to be stronger in EM than DM in the decade ahead. This is not a controversial forecast and simply reflects higher labour force growth (growing the pool of potential workers) and higher productivity growth (there is more capacity for productivity growth in EM due to catch up effects and lower hanging fruit when it comes to economic reforms).

With stable to rising currencies, corporates in emerging markets will be able to convert this top line revenue growth into hard currency earnings in the decade ahead, boding well for future returns.

The net of the above means that, based on our capital market forecasts, EM equities offer a substantial return premium to global and Australian equities in the decade ahead in our “baseline” return scenario.

Coming as no surprise to anyone, this higher expected return comes with elevated risks.

• In forecasting outperformance, we are expecting a different environment in the coming decade than in the previous one. There is a good chance that EM companies again fail to deliver earnings growth due to poor governance, weaker than expected economic growth or myriad other factors. There is also a risk of materially higher inflation and interest rates in DM in the decade ahead. This could disproportionately hurt EM as corporates struggle to finance hard currency debt and foreign investors withdraw capital.

• Even with a Biden administration, tensions between China and the US will not go away. The Holding Foreign Companies Accountable Act, which has been passed by Congress but not yet signed into law, will significantly reduce the number of Chinese companies listed on US exchanges, limiting their access to global capital. President Trump has also enacted an Executive Order which forbids US persons from investing in 31 Chinese companies deemed connected to military activities. Many expect this list to grow. Tensions could continue escalate from here, which would weaken EM equities relative to DM.

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Now probably isn’t the time to fully implement the positive long-term view towards EM equities. Recent performance has been exceptionally strong, market consensus towards EM equities is uniformly positive, vaccine reflation in DM will occur before EM and the Chinese credit impulse is fading. However, if we settle into a more normal environment later in 2021 (assuming interest rates and inflation do not rise materially), we will likely increase the exposure to EM equities towards their SAA weight or above.

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