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Our Investment Strategy group’s capital market assumptions (CMAs) call for EM equities to meaningfully outperform developed markets over the next 10 years — and especially the US, where the gap is nearly four percentage points (Figure 1). Not surprisingly, many asset owners greet these assumptions with a healthy dose of skepticism, given years of disappointing market results and current worries about the global economic and geopolitical outlook.
But as I discuss here, there are reasons to believe that EM equity performance could be much more compelling in the decade ahead, from attractive valuations to economic tailwinds to mean reversion in the US dollar.
Some asset owners’ EM worries stem from the experience of recent years. Clients often remind me that even as managers were calling for EM outperformance and showing charts like Figure 1 over the past five or even 10 years, EM equities were underperforming developed markets by a wide margin (8% annualized over the last decade1). There’s no denying that we are coming off a long global cycle in which including emerging markets in a portfolio didn’t generally improve the risk/return profile.
It’s also clear that emerging markets face structural economic and political challenges. Deglobalization, for example, will be a headwind for countries that have benefited from decades of global free trade. And China, the world’s largest emerging market, will feel the effects of the globalization reversal, as well as demographic shifts (aging population) and the very real prospect of slower GDP growth after a decade of remarkable economic gains.
But I think the case for emerging market outperformance is robust enough to overcome these hurdles. In particular, I see six key arguments:
1. Historical evidence — It’s easy to forget after a challenging decade, but emerging markets have delivered stronger performance than developed markets over the longer term (Figure 2), albeit with more volatility. During the period shown in Figure 2, EM equities had a cumulative annualized return of 9.5% versus 7.9% for developed market equities.
Historically, there has also been a pattern in which a very strong decade for emerging markets (relative to developed markets) has been followed by a weak decade. But on the whole, emerging markets have outperformed by more on the upside than they’ve given back on the downside. So, even after losing a lot of ground in the last 10 years (see Figure 3), emerging markets may well rally with even more force in the decade ahead, with a strong “coiled spring” effect.
2. Attractive valuations — After last year’s market declines, EM equity valuations look cheap both relative to their own history and to their DM counterparts. At the end of April, for example, the Shiller PE ratio for EM equites was less than half that of US equities (11.4 versus 27.5). The spread between US and EM Shiller PEs (16 points) is at the 86th percentile since 2005, meaning it has only been wider 14% of the time. The valuation advantage is a key component of our favorable 10-year CMA for emerging markets above.
3. Economic development — I think economic development remains a secular tailwind for many emerging markets, meaning that their economies are not just growing, but they are transforming and deepening in ways that should support high-quality, sustainable economic progress. For example, they are becoming competitive in a broader set of sectors and seeing growth in their all-important middle-class populations. (Read more on EM development here.) This tailwind should support continued EM diversification, as it makes EM equity performance marginally less sensitive to the global cycle. (On a related note, as I have written elsewhere, we are likely to see increased dispersion in business cycles around the world in the next decade.) EM development should also drive long-term earnings growth — but note that even with this tailwind, we are making the arguably conservative assumption in our CMAs that EM earnings will not grow as fast as US earnings (as shown in Figure 1).
4. Blurring EM/DM distinctions — Recently, we’ve seen developed markets more closely resemble emerging markets in some ways, including facing higher levels of debt and inflation. This increased “parity” around the world may support EM investment and make relatively attractive valuations all the more appealing.
5. Opportunities in China — While China’s economy may not maintain its rapid growth rate in the next decade, that should mean less need for companies to raise equity capital to support large-scale capital formation. As a result, we could see companies focus more on returning capital to shareholders, which would be a positive for equity investors.
6. Mean reversion in the US dollar — When the Federal Reserve eventually begins to back away from its tightening agenda, we could see an end to the dollar’s impressive bull run. That may provide an opportunity for EM equities from the currency perspective — but also given that emerging markets have historically tended to perform better when the dollar is weak.
For asset owners who see the potential for EM outperformance, the next question is how to implement the exposure. I have a strong view that emerging markets are an attractive place to be active, in part because they appear to be less efficient than developed markets. There are also potential shortcomings to consider when it comes to passive strategies, including misalignment between broad cap-weighted EM benchmarks and an asset owner’s goals. For example, many of the largest stocks in the EM index, including energy companies, mining companies, and large multinationals, are closely tied to the economic cycle and not great beneficiaries of the economic development theme discussed above. Active managers may be able to add value by making top-down allocation decisions across countries, overweighting countries that are cheap and underweighting those that are expensive.
I also think the time has come for asset owners to evolve their approach to EM portfolio construction. I recently published updated research on a framework that calls for complementing EM core equity strategies with niche-ier “EM 3.0” strategies that may help round out an overall allocation and improve diversification. Read more on this framework in my paper, EM evolution: New paths in portfolio construction.
1Source: MSCI, as of 31 December 2022
Important disclosures: capital market assumptions
Assumed market returns are based on the Investment Strategy Group’s expectations for future dividend yield, earnings growth, and valuation change. Assumed volatility and correlations are based on historical analysis of the representative indices. Indices used are as follows:
Period — Intermediate capital market assumptions reflect a period of approximately 10 years. If we developed expectations for different time periods, results shown would differ, perhaps significantly. Additionally, assumed annualized performance and results shown do not represent assumed performance for shorter periods (such as the one-year period) within the 10-year period, nor do they reflect our views of what we think may happen in other time periods besides the 10-year period. The annualized return represents our cumulative 10-year performance expectations annualized. The assumed returns shown do not reflect the potential for fluctuations and periods of negative performance.
This analysis is provided for illustrative purposes only. This material is not intended to constitute investment advice or an offer to sell, or the solicitation of an offer to purchase shares, strategies, or other securities. References to future returns are not promises or even estimates of actual returns a client may achieve. This material relies on assumptions that are based on historical performance and our expectations of the future. These return assumptions are forward-looking, hypothetical, and are not representative of any actual portfolio, or the results that an actual portfolio may achieve. Note that asset-class assumptions are market or beta only (i.e., they ignore the impact of active management, transaction costs, management fees, etc.). The expectations of future outcomes are based on subjective inputs (i.e., strategist/analyst judgment) and are subject to change without notice. As such, this analysis is subject to numerous limitations and biases and the use of alternative assumptions would yield different results. Expected return estimates are subject to uncertainty and error.
ACTUAL RESULTS MAY DIFFER SIGNIFICANTLY AND AN INVESTMENT CAN LOSE VALUE. Indices are unmanaged and used for illustrative purposes only. Investments cannot be made directly into an index. This illustration does not consider transaction costs, management fees, or other expenses. It also does not consider liquidity (unless otherwise stated), or the impact associated with actual trading. These elements, among others, associated with actual investing would impact the assumed returns and risks, and results would likely be lower (returns) and higher (risk). Any third-party data utilized in the analysis is believed to be reliable, but no assurance is being provided as to its accuracy or completeness.
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