No discussion about EMs is complete without someone pointing out their insipid returns over the past decade—a paltry 3% annualized in US dollars (including dividends). While the composition and computation of the MSCI EM index depress its headline returns somewhat, the broad assertion that EM returns have been forgettable is true.
They pale even more in comparison with the S&P500’s nearly-13% dollar return over the same period. Global asset allocators have been feeling vindicated in opting for US markets over EMs.
People tend to judge a movie by the size of crowds that come to watch it. By that yardstick, the EM movie seems like a flop, but regular moviegoers will notice that the show has gotten better and promises to improve further. To begin with, the tickets are cheap. The 12-month forward price-earnings (PE) ratio for EMs is barely 12 times.
This is not only cheap versus its own history, it reflects a discount of over 40% to US markets, the widest gap in a decade. Sizeable EMs like Brazil, Korea, Poland and South Africa are trading at single-digit PE multiples.
Add to this a 3% dividend yield that the EM index offers, and the valuation case becomes more compelling. Consensus forward return-on-equity of nearly 13% and earnings growth in excess of 20% should allay fears that EMs are a value trap.
In most EMs, private-sector balance sheets are in a better shape than they were five years ago. Remarkably, for a period that included the pandemic disruption, the level of private-sector indebtedness has reduced. Moreover, average public debt as a proportion of GDP among EMs is less than 60%, with no large EM in any sort of fiscal crisis.
A significant exception to this trend of lower leverage is China, which has continued to pile on debt across private and government balance sheets.
While attractive valuations and strong balance sheets provide a floor to the asset class, the investment case for EMs will likely grow stronger with easing of interest rates. The inflation experience in Asian EMs over the past couple of years has been more benign than in the developed world.
While Latin American and European EMs did see sharp inflation spikes, price levels there have cooled off too. Many EM central banks raised rates ahead of the US Federal Reserve, and with relatively well-behaved inflation numbers, real rates are now significantly positive, even as absolute rate levels remain high. Over time, once the Federal Reserve cuts rates, many EM central banks will likely follow suit, which could provide a monetary fillip to growth.
The International Monetary Fund (IMF) predicts that the growth rate difference between EMs and developed markets (DMs) will widen to 2.4 percentage points by 2025 from 1.4 percentage points in 2022. Historically, this gap along with a weakening dollar has provided the base conditions for EM equity outperformance.
It is also worth noting that when compared in real-effective-exchange-rate terms, the average EM currency is now trading close to its lowest level against the US dollar in over three decades.
The country that is following a different path from this macro storyline is China. Its nominal GDP growth has decelerated sharply, and its twin headwinds of elevated debt and deteriorating demographics will likely put a lid on its structural growth prospects.
Net exports and investments, which were China’s erstwhile engines of growth, are now stalling, while the Chinese consumer remains a circumspect spender, preferring to stash surplus savings in low-yielding bank deposits. Recent government actions may have temporarily stabilized China’s real estate and onshore stock markets, but the path out of its current economic situation remains hazy.
Despite its bleak macro picture, China remains an $18 trillion-economy accounting for a fourth of the MSCI EM index. Given the size of its market, finding good bottom-up investment opportunities in China is not a lost cause. We can expect investor interest to converge on attractively valued large dividend-yielding companies in sectors relatively insulated from policy intervention or firms that have ventured into overseas markets and are proving to be formidable global competitors.
Another distinguishing feature of the EM asset class is that it comprises heterogenous countries that do not have a common monetary, fiscal or trade policy. This means that individual macro themes are important. Countries like India and Indonesia, for example, have a strong domestic consumption base, while Poland and Vietnam are export powerhouses.
Greece is coming out of a decade-long balance sheet repair process, while Mexico is benefitting from the American push for ‘near-shoring.’ A passive EM investor ends up investing in these countries primarily based on the size of their equity markets, which is not an optimal way of allocating money within this asset class. An active fund manager, on the other hand, is able to make choices based on their relative macro merits.
Multi-year low valuations and balance sheets that are well-placed to support growth generally excite bottom-up investors. Emerging markets happen to be at that juncture now.
These are the author’s personal views.