May 12, 2017, Jean-Jacques Ohana and Dr. Christian Witt (both YCAP Asset Management)
Over the last year, emerging market equities have outperformed stocks in the developed world by a wide margin (see Figure 1). Developed market equities outside the US, many of which mired in political risks, have done particularly bad. With such political risks now subsiding, investors may attempt to aggressively return to formerly neglected developed markets in search for a catch-up rally. While we are generally friendly to this investment thesis, emerging stock markets may be an alternative worth considering. Why? Economic fundamentals, valuations and technological catch-up.
Favorable Long-Term Economic Conditions
In its simplest form, economic growth theory describes two principal sources for GDP per capita growth: Productivity growth and demographics. Perhaps apart from North Korea, the former is essentially available to any country in the world as free trade ensures the dissemination of technological advances around the globe (this may be precisely why populists aim at erecting new trade barriers). The latter accordingly seems better suited to forecast where per capita GDP will rise the most.
Projections of working age populations clearly show demographics will be much more favorable for emerging economies than their developed peers (see Figure 2). However, there are some tremendous and perhaps surprising differences across countries (see Figure 3). Until 2045, three major population centers––China, the Euro Area and Russia––will see a declining working age population. Meanwhile, the world’s second most populous country, India, is set to outgrow all other selected countries by a wide margin. Another stunning finding is that the USA may see its working age population rise at about the same pace as the global average, much higher than the one for developed markets, comparable to those of South Africa or Indonesia. So, although demographics tend to favor emerging markets, one needs to be aware of regional differences.
‘Disturbances to efficiency’––say corruption, weak institutions, social tensions or warfare––likely constitute the most relevant impediments to the predictions economic growth theory offers. Not only are they ignored in theory, but have also concentrated in emerging economies. So, investors clearly need to be aware of this issue. Positive examples, e.g. China, South Korea or Taiwan, demonstrate, however, how investors can benefit from an additional upside if governments in emerging markets succeed in reducing such disturbances. Hence, unless poor governance interferes, there is a solid economic case for investing in emerging economies.
From a more technical angle, comparatively low equity valuations (see Figure 4) add another argument in favor of emerging markets. Using the price-to-book ratio as a proxy, emerging equity markets have historically traded at a discount to the US stock market. But rarely has the premium of US stocks above emerging equities been so considerable. Critics may correctly argue that the steep discount reflects inefficiencies in the management of public companies in emerging markets. However, developed market equities outside the US have also trade at a similar discount for a little more than a decade despite being subject to the same governance principles and investor scrutiny as in the US.
Still, emerging markets offer a much higher growth potential than in developed Europe or Asia due to superior demographics. Emerging stocks accordingly appear cheap, at a minimum compared to European stocks.
Stock Performance Linked to Global Business Cycle
A potential weakness of the preceding argument is the close relation between emerging market stocks and the global business cycle. For when the global economy (surprises) disappoints, emerging markets outperform (underperform). As Figure 5 illustrates, the performance of national emerging market stock indices over the last year has largely tracked improvements in the global PMI, a proxy of the business cycle, albeit not perfectly. This demonstrates the dependence of emerging markets on global growth.
On the positive, the favorable combination of globally available technology and positive demographics imply ample potential for capital appreciation. The flipside is that a supposedly diversified portfolio of emerging market stocks may in fact be highly correlated in a downturn.
In the short-term, it is unclear which way the global economy may go. While global PMIs still indicate a continuing expansion, stagnating commodity prices and a falling US manufacturing PMI can be seen as red flags. Investors should also take into account that the correlation of emerging markets towards commodities, one of our favorite indirect indicators of economic momentum, varies widely. At the moment, we barely see any relation to crude (see Figure 6), merely a loose one to copper (see Figure7) and iron ore (see Figure 8), but a strong co-movement with the materials sector (see Figure 9).
But being risk-conscious investors ourselves, we hesitate to take on too much risks. One possibility to reduce risks would be to follow Jeffrey Gundlach’s advice (presentation and video) and hedge the (directional) crash risk by going long the MSCI Emerging index and simultaneously shorting the US stock market. Such an approach may still benefit from converging valuation. Another way would be to wait until the next correction before investing into emerging equities.
Technology Made in Emerging Economies
In the last step, we break down the performance of the MSCI Emerging index by sector (see Figure 10) to better understand the industrial dynamics at play. It turns out that the technology sector is by far the best performing industry, with materials coming in second.
More importantly, the technology sector seems to offer both return and diversification potential. From a return perspective, technology stocks have continuously outperformed the MSCI Emerging index over the short to long term (see Figures 12, 13) and kept doing so when other sectors have moved sideways (see Figure 11). From a diversification perspective, the sector has outperformed all four BRIC country indices (see Figure 11). This illustrates that technology stocks, and thus sector performance, are spread across different emerging economies (see Table 1).
Next, we compare the MSCI Emerging Technology index with the NASDAQ 100, arguably the most relevant benchmark of developed country technology stocks. Figure 14 reveals that, since 2011, the NASDAQ 100 has staged a spectacular rally resulting in a cumulative outperformance of nearly +95% compared to its emerging market peer. Impressive as this may sound, considering emerging market technology stocks still appears reasonable in a portfolio context. For over shorter time frames, such as the last 12 months, the MSCI Emerging Technology grew more than +15% faster than NASDAQ. On top of that emerging market technology firms offer the easiest way to tapping favorable demographics. So, the MSCI Emerging Technology index looks once again attractive both in terms of return and diversification opportunities.
Therefore, investors with an interest in emerging markets or technology stocks should closely follow the companies of the MSCI Emerging Technology index.
The Case for Emerging Equities
To sum up, the case for emerging market stocks is based on sound long-term growth prospects paired with favorable valuations. The biggest caveat we see is the high dependence of emerging equities on the business cycle which could markedly reduce diversification. In the light of current macro-economic conditions, investors may prefer to avoid directional exposure for the time being by either waiting for the next correction or entering long-short positions. Last but not least, from a sector perspective, the MSCI Emerging Technology index adds a valuable option to diversify both a global technology stock or emerging market portfolio. In any case, emerging markets are worth a look!
Figure 1: Performance of MSCI Emerging vs. MSCI ACWI and MSCI EAFE
Figure 2: Projected Working-Age Population Growth in Developed and Emerging Economies (Calculations: YCAP AM, Data: Oxford Economics)
Figure 3: Projected Working-Age Population Growth in Selected Developed and Emerging Economies (Calculations: YCAP AM, Data: Oxford Economics)
Figure 4: Price-to-Book Ratio for the MSCI Emerging, MSCI ACWI and MSCI USA
Figure 5: Global Composite PMI and the Performance of Selected Emerging Stock Markets
Figure 6: Performance of Crude Oil and Selected Emerging Stock Markets
Figure 7: Performance of Copper and Selected Emerging Stock Markets
Figure 8: Performance of Iron Ore and Selected Emerging Stock Markets
Figure 9: Performance of the MSCI Emerging Materials Index and Selected Emerging Stock Markets
Figure 10: Global Composite PMI and the Performance of Selected MSCI Emerging Sector Indices
Figure 11: Performance of the MSCI Emerging Technology Index and Selected Emerging Stock Markets
Figure 12: 10-Year Performance of the MSCI Emerging vs. the MSCI Emerging Technology and Materials Sectors
Figure 13: 1-Year Performance of the MSCI Emerging vs. the MSCI Emerging Technology and Materials Sectors
Figure 14: 10-Year Performance of the NASDAQ 100 vs. the MSCI Emerging Technology
Figure 15: 1-Year Performance of the NASDAQ 100 vs. the MSCI Emerging Technology
Table 1: Top 10 Holdings of MSCI Emerging Technolog
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