By comparing the returns of developed markets to emerging markets (EMs) using the building blocks of earnings per share (EPS) growth, income, valuations and total return, it’s easy to see why EMs haven’t performed as well over the past decade.
Using the building blocks approach to generating asset class returns allows investors to consider the key fundamental drivers of longer-term performance. And emerging market economies are particularly useful case studies when assessing potential returns using this approach.
Many investors are attracted to EMs primarily because of their high growth rates, assuming that returns will follow. However, there are a number of potential wedges between what appears to be high growth rates and actual returns.
For instance, to estimate sales growth, investors can use a measure of trend nominal GDP growth which, in turn, reflects population growth, productivity growth and inflation. In the case of EMs over the past 10 years, this was around 6 per cent.
This compares favourably with developed world growth of around 3.5 per cent, yet the return from developed markets was more than 12 per cent compared with EM returns of 5 per cent.
So, what happened to all that growth?
Valuation changes are, of course, one of the key drivers. In developed markets, a combination of moderate growth, declining inflation and low, declining bond yields under central bank quantitative easing (QE) helped propel market valuations higher, adding around 5 per cent per annum to overall returns.
Conversely, EMs saw more modest price to earnings expansion, reflecting less QE support, a stronger US dollar, a declining growth premium and, more recently, concerns over China.
Furthermore, while profit margins expanded in the US, margins tightened up slightly in EMs as wages growth lifted and productivity waned.
Another relative headwind for EMs was the capital structure. Historically, emerging markets tend to have higher net new share issuance (and lower buybacks) than the US and some other developed markets. In other words, the top line growth was diluted.
What about the outlook?
Looking forward – and using the key building blocks approach – investors need to ask themselves a number of questions:
What is the outlook for nominal GDP growth?
What is the outlook for margins?
What is the outlook for valuations and PE multiples?
What is the outlook for dividends?
The nominal growth input changes slowly from year to year, although with potentially higher inflation going forward, top-line sales growth estimates are likely to be higher for both developed and EMs compared to the past 10 years. Margins are extreme in developed markets and may revert to a longer-term mean or regime-dependent version of that. The valuation input to returns can vary significantly each year – as the last couple of years have shown – but will struggle to replicate the contribution to returns witnessed over the past decade. For EMs in particular, the key questions will be whether valuation discounts remain large (currently 30 per cent to developed markets) or will these return to a longer-term average (around 20 per cent).
There has been a trend in recent years to expect that longer-term return assumptions are declining across most asset classes. This is true, although capital markets assumptions need to reflect extreme valuation swings. For example, following the sell-off in markets in March 2020, we factored in a lift to long-term return assumptions for equities and related assets and cut bond return forecasts. In the upcoming SAA review, in light of the run-up in market valuations and inflation risks, these return projections will once again be under the microscope.
Our longer-term return assumptions generally look through the business cycle and are more heavily influenced by the type of inflation regime unfolding, and the implications for the pathway for nominal growth and interest rates.
Over the shorter term, turning points in the cycle play a much greater role as do changes to monetary and fiscal policy settings. Short-term returns are also driven by valuations. In 2020, valuation changes were the predominant driver of returns, although leadership of returns changed in 2021 from valuations to actual EPS growth in the case of equities and REITs. This is likely to be the case again in 2022 as policy and liquidity conditions deteriorate.
From a portfolio construction perspective, an improving characteristic for EMs for Australian investors is its correlation with Australian equities has declined, as has its volatility. The characteristics of EMs have of course changed, with resources no longer being a significant weight, reflecting the growing importance of China in the index. No doubt the attributes of EMs exposure will change further over the decade ahead.
While EMs continue to offer a stronger growth outlook and valuations look more compelling than for developed markets, the growth premium for EMs continues to decline as China matures and geopolitical risks and policy remain at the forefront of issues to consider, requiring valuation compensation.
In the context of which asset classes are expected to generate growth over the coming period, it’s less a case of the asset class itself, and more about the building blocks that drive longer-term, sustainable returns.
Damien Hennessy is the head of asset allocation at Zenith Investment Partners.
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