The past 15 years have been challenging for emerging-market equities. A persistently strong US dollar and underwhelming earnings growth converged to create a difficult environment for the asset class. That backdrop now appears to be changing. Several of the headwinds that defined the past decade and a half are beginning to ease, while the underlying composition of the asset class has evolved in ways many have overlooked. Together, these shifts suggest the investment case for emerging markets deserves a fresh look.
A different backdrop
The US dollar is the obvious place to start. Over the past seven decades, dollar cycles have typically lasted around 17 years from peak to trough to peak. The current cycle is now more than 20 years in length. That does not guarantee a turning point, but it does suggest the balance of probabilities may be shifting.
The relationship between the dollar and emerging markets is well recognised, although the strength of that relationship is less understood than its direction. Even so, the historical evidence is difficult to ignore. For example, over the past 25 years, there have been 10 years when the dollar weakened, nine of which saw emerging market equities outperform their developed market peers, with an average return of around 31%. Last year followed a similar pattern, with the dollar down around 8% and the asset class returning 34%.
The second shift is taking place in China
Between 2014 and 2020, heavy equity issuance diluted earnings growth across the market. Even where companies generated stronger profits, shareholders often saw little benefit because the share count continued to rise.
That dynamic has changed. Faced with weaker domestic demand and a more uncertain geopolitical backdrop, Chinese companies have become noticeably more disciplined in how they allocate capital. Buybacks and dividends have become increasingly common, marking a significant departure from the previous decade. The reversal runs both ways: American companies are now issuing equity and pursuing new listings at a pace that would once have looked distinctly Chinese over the late 2010s.
Consensus expectations reflect that improvement. Emerging market earnings are forecast to grow by around 50% this year and 23% next year, compared with 24% and 14% respectively for the MSCI ACWI. These are market expectations rather than proprietary forecasts, but they nevertheless point to a materially different earnings backdrop.
Valuations reinforce the picture.
Despite last year’s strong performance, emerging markets continue to trade at close to a one-standard-deviation discount to their 10-year average and sit in roughly the nineth percentile of relative cheapness compared with US equities over the past 35 years.
History suggests these starting points matter. When emerging markets have traded at similarly depressed relative valuations, the following five years have delivered an average uplift of around 50 percentage points relative to US equities. Buying when valuations have been expensive has historically produced the opposite outcome, with an average shortfall of around 36 percentage points.
Taken together, the combination of improving earnings expectations and still-attractive valuations suggests this is not simply a story of expanding multiples. Instead, this increasingly looks like an earnings-led rally rather than one driven by higher valuations alone.
More than a valuation story
Valuation alone would not be enough to justify a more constructive view. The quality of earnings is arguably just as important.
Our emerging market exposure includes what is referred to internally as the ‘Secret Seven’: a group of leading emerging market technology businesses that includes companies such as Samsung, TSMC and SK Hynix.
Compared with their US counterparts, these businesses generally carry stronger balance sheets, maintain net cash positions and reinvest a greater proportion of operating cash flow back into their businesses.
That discipline is reflected in earnings expectations. Forecast earnings growth for the Secret Seven is almost double that of the Magnificent Seven, despite investors paying lower valuations for that growth. That valuation advantage persists even after excluding Tesla from the comparison.
The opportunity also reflects the growing disconnect between economic importance and market representation.
Emerging markets account for around 80% of the world’s population, 59% of global GDP and 53% of global manufacturing value added. Yet they represent only around 12% of the global equity benchmark and, on average, closer to 6% of active global equity portfolios.
Why implementation matters
Emerging markets have always been an exceptionally cyclical asset class. Over roughly three-quarters of the past two decades, they have ranked either among the best-performing major asset classes or among the weakest. That makes implementation at least as important as the allocation decision itself.
Style-based investing has not consistently reduced that cyclicality. Take, for example, a simple 50/50 blend of emerging market growth and value. While such a combination might be expected to reduce volatility in practice, the cyclical nature of the asset class has often produced the opposite outcome, amplifying volatility rather than reducing it. For that reason, a core allocation is better suited as the anchor, with any style-specific tilts used as smaller satellite exposures around it.
The same principle applies at the country level. Country leadership changes far more quickly than many investors expect. Mexico and Brazil represented almost one-fifth of the benchmark at the turn of the century; today, they account for closer to 6%. Latin America illustrates just how difficult country allocation can be. It was the best-performing region in emerging markets last year, returning 51%, after emerging markets overall had fallen 25% the year before, and after Latin America itself had returned 35% the year before that. The lesson is not to chase country performance, but to let active managers pick stocks rather than countries.
Governance also remains an important differentiator. Many emerging market companies remain founder-led or state-controlled, making governance analysis a critical part of the investment process. In one instance, upon closer scrutiny of an airline that appeared fundamentally attractive, it emerged that the board of directors were seeking to have the company’s founder removed. The founder’s response was a poison pill: proposing his own two-year-old son for a board seat. The investment was understandably avoided. It illustrates why governance analysis remains such an important part of investing in emerging markets.
Examples like these illustrate why active management can add value beyond simply identifying attractive businesses. Emerging markets remain an alpha-rich asset class, with the median active manager having consistently generated alpha above the benchmark over time. Low correlations between individual stocks also create an environment where stock-picking can meaningfully add value.
What it means for South African investors
For South African investors, the case extends beyond return expectations. The excess returns generated by our emerging market equity strategy have historically shown relatively low correlation with the JSE, reflecting very different underlying drivers. South African equities remain closely linked to domestic economic conditions and commodity cycles, while broader emerging markets provide exposure to structural themes such as India’s expanding consumer economy, Korean and Taiwanese technology, and Latin America’s evolving political cycle.
Blending an allocation to this strategy with domestic holdings has historically improved outcomes, with even a modest position helping to enhance returns while reducing overall portfolio risk.
Although there were good reasons to be cautious about emerging markets over much of the past 15 years, those conditions appear to be evolving today. The dollar may be entering a different phase, earnings expectations have improved, and valuations remain supportive despite the recent recovery. At the same time, the underlying composition of the asset class has changed, with higher-quality businesses playing a much larger role than they did a decade ago.
For South African investors, that creates two distinct sources of opportunity. One is the potential for stronger long-term growth. The other is the diversification benefit that comes from accessing a broader set of economic and market drivers than those available through the domestic market alone. Together, they make a compelling case for taking a fresh look at an asset class that has spent much of the past 15 years out of favour.
