Let’s be clear – anyone hoping for strong returns from global emerging markets in recent times has been left disappointed as a strong US dollar, trade tensions, a global pandemic, inflation and war have all hit the asset class hard.
In the past decade, the MSCI Emerging Markets index has returned less than a third of the returns from the MSCI World (225% vs 77%), while Covid-19 hit the region particularly hard due to its heavy manufacturing output (working from home is not really an option for this sector bringing production to a halt) over the past year.
Then there is Russia’s invasion of Ukraine. This has resulted in sanctions on the former, which, given it is a significant producer of oil and gas, caused inflationary pressures across the globe. Again, this places pressure on the manufacturing sector given its energy requirements.
Better growth to come?
The International Monetary Fund forecasts that economic output across emerging markets will expand by 3.8% this year and 4.4% in 2023. Both figures have been revised down sharply since last year but there is hope as these figures are still comfortably ahead of those for advanced economies.
With the threat of Covid starting to fade, the benefit of rising commodity prices and the move to a new economic cycle where US equity market performance may not be as stellar as it has been in the past 10 years – could emerging markets finally present an opportunity to investors?
The first thing I’d point to is the region does demonstrate attractive earnings expectations, when compared to its peers. As GAM investment director Tim Love points out, despite the higher beta of emerging markets in the first few months of 2022, the region still has strong fundamental and valuation support, as well as earnings per share resiliency – all of which is supportive to the asset class.
Figures to the end of April 2022 confirm how under-owned and undervalued the asset class is, with the S&P 500’s current forward price to earnings ratio (PER) of 19x while the Hang Seng China Enterprises Index and MSCI EM’s PER are significantly lower at 7.5x and 9.8x respectively.
Add the fact that many emerging markets have de-rated over the past 15 years and there is significant potential for outperformance over developed markets from here.
While Russia’s invasion of Ukraine was a high-risk event across the globe, the decline has been disparate across emerging markets. Emerging European nations like Hungary, Poland, Czech Republic, Greece, and Turkey have been some of the worst performers given their dependence on Russian energy, grains, and tourism. On the other hand, Latin American markets have benefited from higher commodity prices.
Beyond Latin America, Saudi Arabia and South Africa have also recorded strong performance as they have the next-largest market exposures to commodities.
Food supply pressures do, however, remain a significant concern – for example, a total of 80% of Egypt’s wheat imports come from Russia and Ukraine.
I also want to touch on environmental, social and governance (ESG) here – this is where emerging markets play a role on two fronts. Firstly, significant improvements in ESG considerations are being made in the likes of China, South Korea, Taiwan and India, but perhaps what is not as well-documented is the importance of many emerging markets in the drive towards net zero – something which is likely to be accelerated by the concerns around energy supply due to the outbreak of war.
Moving to a world of secure energy puts significant pressure on production of certain commodities, many of which are concentrated in a handful of countries in emerging markets.
In certain cases, a single country accounts for more than half of worldwide production – South Africa in platinum, China in rare earth elements – while even copper and nickel have more than half of current production coming from just three countries. That’s without talking about the rise of electric vehicles (EVs) – which requires 6x the mineral inputs of a conventional car.
It would be remiss of me to talk about emerging markets without mentioning the two heavyweights – India and China, given their influence on the region.
India clearly has significant tailwinds through strong demographics, growth, few geopolitical concerns, strong corporate governance and the growing online economy.
Although valuations look stretched in the short term, you are paying a premium for the security India offers compared to its emerging market peers and there is a strong argument that this is the long-term growth market to invest in.
China’s challenges are well-documented, with its Covid zero policy and the overhanging threat of government intervention. But with the market down almost 30% in the past 16 months there is no doubt it looks cheap – it’s also in a different cycle to the rest of the world given it is cutting rates.
Ultimately, Chinese fortunes can turn quickly. For example, it was not that long ago that a speech from China Vice Premier Liu He’s – in which he addressed key market concerns around stabilising the property market and providing clarity on technology regulation – resulted in the biggest one-day rebound ever seen by Chinese shares.
It's been anything but smooth sailing for emerging market investors since the global financial crisis, but there is cause for optimism that a changing economic cycle, coupled with a number of long-term tailwinds, could present significant opportunities for investors.
Darius McDermott is managing director of Chelsea Financial Services. The views expressed above should not be taken as investment advice.