Should Emerging Markets Be in Your Portfolio?
September 6, 2023
2023 so far can best be described as yet another year in 10+ years of developed markets dominance over emerging markets. Year-to-date, emerging market equities are up only ~4% vs ~15% for developed markets, as measured by MSCI. The pattern holds true for 5 years (~0% vs ~8% per year) and 10 years (~3% vs ~9% per year) as well. The 2010s were clearly a decade for developed markets.
While this decade has started much the same way, there are several reasons to think the trend may not last. First, Emerging Markets (commonly abbreviated as EM) are drastically under-represented in equity markets. While EM makes up only ~20% of global equity market cap, these markets contribute ~50% of global GDP in USD terms and ~60% in purchasing power parity terms. They hold 55% of global FX reserves and are responsible for ~60% of global energy consumption and ~80% of global oil production. Most importantly for the very long term, EM accounts for 80% of land area and 90% of the human population. In other words – emerging markets are too big to ignore.
First, let’s establish which markets are classified as emerging (see EM classification below). MSCI evaluates equity markets around the world each year to determine whether they are developed, emerging, frontier or standalone markets. Investopedia says, “An emerging market economy is transitioning from a low-income, less developed, often pre-industrial economy towards a modern, industrial economy with a higher standard of living.”
Second, it’s important to understand the past to plan for the future. A big reason for recent EM underperformance has been China: -5% per year for the last 5 years. The problems are well telegraphed: decreased exports as western consumers focus on services, a property crisis, and a post zero-covid confidence scare. However, we may be nearing the bottom. Beijing has slowly rolled out stimulus over the last 2 months, and we expect more to come. China’s “weak” economy is still expected to grow at 4-5% this year and has no inflation, leaving plenty of room for stimulus. Consumers are spending, but on smaller ticket items and services, just like in the west. Big ticket personal and corporate investment is suffering, but that tide will likely turn as zero-covid PTSD fades. And lastly, there are initial signs of a bottom in global industrial & manufacturing activity, likely leading to an improvement in China’s exports in 2024. Importantly, China’s productivity levels are at ~20% of US levels (compared to ~70% in Japan in the 80s) so there is plenty of room to grow output despite demographic challenges. In short, the drag from China may well turn out to be a tailwind over the next few years.
Lastly, valuations and positioning tell a compelling tactical story. At the end of July, developed markets had a forward PE of 18x vs 13x for emerging markets. Though EM typically trades at a discount, it is now at stretched levels and offers an interesting entry point. In addition, positioning is extremely light as most investors have exited EM over the last 6-9 months, either due to geopolitical reasons or due to fear of missing out on the U.S. rally. As a result, there are few sellers of EM left, creating a sizable gain scenario in EM vs DM equities should the consensus change.
Investments in emerging markets may be more volatile and less liquid than investing in developed markets and may involve exposure to economic structures that are generally less diverse and mature and to political systems which have less stability than those of more developed countries.
This material represents an assessment of the market and economic environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. Forward-looking statements are subject to certain risks and uncertainties. Actual results, performance, or achievements may differ materially from those expressed or implied. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor. Past performance does not guarantee future results.