In the crossfire: revisiting the investment case for emerging markets

Ninety One is familiar with the questions and doubts about emerging market (EM) investing. We understand asset allocators want context and insights, so we set out to reassess the long-term case for investing in EM assets.

To gain a diversity of views, our Investment Institute convened a series of roundtables among all our investment teams, each of which operates autonomously. The Institute develops analysis independently of any single strategy within Ninety One and tested the case for EMs agnostic of a particular approach.

A decade ago, asset allocators saw compelling return forecasts for EMs, attracted by high revenue growth and resilient margins among quality companies in countries that were quickly building wealth. The investment opportunity held promise. Since then, though, assets have generated lacklustre returns relative to that promise, with investors now questioning the usefulness of EM beta in portfolios.

What happened?
What changed and what did not?

We wanted to understand the nature of the forces that impacted those assumptions, dig into the investment case, and offer an analysis of the long-term scenario for EMs. At the same time, we felt it necessary to revisit the investment case for cyclical assets around troughs in cycles, when behavioural mistakes are more common.

In equities, on the face of it, the picture is stark. EMs have underperformed global equities over the last 3-, 5- and 10-year periods. This is clearly sobering for the EM investor.

And yet, there is nuance.

Assessing equity returns from a single vantage point today does not capture investors’ experience over time, which is better illustrated through rolling returns. Since 2001, EM returns have exceeded returns for global equities half the time. This is measured using 1-year rolling total returns in hard currency.

From 2002 to 2011, EMs outperformed global equities almost 90% of the time. Returns in the past decade were challenged because of a strong derating in China and commodity-heavy economies.

Still, on a bottom-up view, EM equities presented compelling opportunities. In the US, over an exceptional past decade, many companies outperformed. But beyond North America, EM companies made up half the top 100 performers in the ACWI - notwithstanding the US dollar tailwind, Russia plunging to zero, and the impact of policies related to ‘Common Prosperity’ and zero COVID in China.

Outside of the US, the last decade unveiled a rich opportunity set in EM

Source: MSCI, calculations performed by Ninety One, 10 years to June 2022. MSCI ACWI ex-North America.
For further information on indices, please see the Important information section.

Indeed, EMs usually outperform developed markets (DMs) ex-North America. To put it another way, unless investors want to allocate 100% of equity allocations to the US, EMs are competitive.

Anchoring the argument behind EM equity allocation and return expectations has been a view that higher GDP per capita growth would translate into better EM company performance. We found the connection between nominal EM revenues at the index level and nominal GDP growth per capita exists and endures across many different countries. There is extensive theoretical discussion underpinning this view, but the simple link between GDP and revenue growth is important because EM revenue growth is likely to exceed DM revenue for the foreseeable future.

Equities have different sources of returns – dividends, corporate and economic growth, issuance and revaluation – and it is useful to analyse each. When we do, it is clear the correspondence between per-capita GDP growth and top-line growth, which many doubted, is strong. Given EM growth will probably exceed DM growth for many decades, this is a critical finding. Our analysis support the reasons most allocators 10 years ago and earlier concluded investment in EM equities would be beneficial – the outlook for revenue growth and margin stability.

The link between revenue growth and GDP per capita is strong

Source: Bloomberg, Ninety One. Calculated over calendar years from 1999 to 2021.

So why were the capital market assumptions for EMs flawed?

EMs have faced three idiosyncratic events over the last decade. They are identifiable – and they are also unlikely to repeat. Asset allocators would not have seen these events reflected in the forecasts of 10 years ago. They were not anticipated.

01 Chinese indices underwent seven large index rebalancing events in recent history. Chinese equities came into the EM index at peak or high valuations and those companies subsequently saw their earnings growth and multiples derate meaningfully. ADR and A shares inclusion events accounted for 40% of China net issuance since end-2014, and 20% of EM net issuance — both high numbers for technical, one-time index inclusion events. Chinese equities then derated substantially. They traded, as a whole, at 10x forward earnings in 2022 versus 13x during the index inclusion events. The extent of the derating was particularly severe for ADRs. For instance, the collective forward multiple on Chinese ADRs as they entered the index was around 25x, and they subsequently went below 15x. While index inclusion does not typically play a starring role in explanations of equity performance, the scale of recent change in China have put them front and centre in our narrative. Given the lack of euphoria in Chinese assets today, that is unlikely to repeat.

Premium/discount on stocks entering MSCI China

Source: Ninety One calculations, FactSet, MSCI and Goldman Sachs Global Investment Research.

02 The cycle did not favour EM sector composition. The three biggest EM sectors at end-2011 were financials, energy and materials, making up 51% of the index (these same sectors made up 29% of the US index and 39% of the ACWI). Each of these sectors went on to underperform the EM index. EM IT in fact outperformed ACWI IT over the 20 years from end-2001 to end-2021, and was the second highest-returning GICS 1 sector when one lines up EM and ACWI sectors.

03 The opportunity cost of investing in EME has been extreme due to US exceptionalism. In no other region but the US did margin expansion, net issuance, FX and multiple expansion all contribute to returns. As of late 2021, net margins in the US were in the top fifth percentile of outcomes in the last century. Valuation multiples were in the top second percentile since the late 19th century. The dollar is at nearly a 35-year peak. Buyback activity is also elevated relative to history.

The point here is not to predict US outperformance will end at a particular time. The point is that it would be unprecedented for the US through this decade to perform similarly to the last decade. Less US outperformance means a lower opportunity cost of investing in EM going forward.

In addition, there are cyclical considerations for EMs. On the timing front, EM assets typically do very well after dollar peaks and when growth data is strong. On valuation, there is clearly a case. US equities are now at high multiples relative to history, while EM multiples stand one-fifth below levels since 2000. Yes, EMs are more cyclical, but their volatility is reducing and implied equity risk premia differentials have been consistently positive.

Finally, while we are in the middle of a geopolitical shift from a unipolar moment to a multipolar world, this does not present a reason to avoid EMs. There are two reasons why not. First, US-China rivalry is creating new opportunities for EMs. Witness, for example, the manufacturing booms in India and Vietnam. Second, localisation rules are limiting the Starbucks approach to investing – particularly in healthcare and technology.

In fixed income, we also have an immediate snapshot that appears sombre. The recent drawdown has been challenging.

Just as with equities, however, the underperformance story is complicated. Rolling returns show most EMFI asset classes have outperformed their relevant DM comparators over two decades. Meanwhile, EM corporates have notched the highest risk-adjusted returns for most asset classes over 5, 10, 15 and 20 years.

Dollar-denominated EMFI asset classes have delivered strong returns

10-year risk vs return

20-year risk vs return

Source: JP Morgan, MSCI and Bloomberg. Compiled by Ninety One as at 31 August 2022.

Also, underlying risk premia in EMFI remain intact because EM assets are treated as riskier than they actually are.

Within EM local sovereigns, strong yields have underpinned returns over the longer term. In the shorter term, currency changes have impacted returns. Within EM dollar debt, returns have been supported by strong spreads and duration returns, even during the difficult last decade. Rolling credit returns are consistently positive, i.e. above zero, which indicates the yield is not eroded by loss of credit quality. In other words, EMs are treated as riskier than they are.

While there is sufficient risk premium embedded in the asset class via higher bond yields, the actual outcomes are going to be influenced by other considerations. These include FX and cyclicality. Allocators must take these into account to make allocations at the right price, in the right manner, and in the right portfolio context.

Local currency sovereigns have relied on strong yields

Source: Bloomberg, JP Morgan, Ninety One. As at October 2022.

Yes, fixed income is currently in a bear market, driven by rising inflation, central bank policy tightening and the higher volatility of inflation and rates. Yes, also, there are cyclical reasons to be attracted to fixed income assets. These include extremely high yields relative to history, being closer to the end of the EM rate-hiking cycle than the beginning, stronger economic fundamentals, and, potentially, structural shifts in the flow of dollars given geopolitical flux.

Beyond these considerations, we must remember why asset allocators were first drawn to EMs. They wanted to participate in the long-term structural shift in the gravity of the world economy towards the east and the south. This trend endures.

EM equity and fixed income market capitalisations as a share of global assets have only gone in one direction, even during a difficult decade like the past. While there is a concern deglobalisation is going to hurt EMs, just as globalisation has been a benefit, this misconstrues the nature of trade flows which were always predominantly regional and, also, fails to account for new opportunities for EMs.

Cutting through the news-flow at any given moment, what supports growth in EMs is human capital convergence, which is inexorable. In addition, as allocators commit to financing a transition to net zero, drawn by attractive risk-adjusted returns, a greater flow of physical capital into EM assets will enhance infrastructure and economies, in turn attracting greater flow.

Where does this leave asset allocators today?

As George Orwell once said, it can take effort to see what is happening right in front of one’s nose. We know investors tend to swing between extremes when it comes to EMs, and that we are close to or even at one of those extremes. Structurally, however, the picture is less volatile. It remains a fact that longer- term global economic momentum is shifting away from advanced western economies and EMs are constituting a larger share of economic activity. Absent a further geopolitical shock of great magnitude, the fundamentals make the case for the inclusion of EMs in a portfolio.