In this investment climate, developed markets will be problematic — at best. Emerging markets (EMs) would seem beyond the pale.
To start with, EMs’ track record over the past decade hardly inspires confidence. They have underperformed global equities over the past 3, 5, and 10-year periods, with history telling us that at times of uncertainty, dislocation, and ructions, they stand in the crossfire.
It’s a sobering picture. And yet, there is nuance. Since 2001, EM returns have exceeded returns for global equities half the time as measured by using one-year rolling total returns in hard currency. From 2002 to 2011, EMs outperformed global equities almost 90 per cent of the time. Returns in the past decade were challenged because of a strong Chinese derating, commodity-heavy economies, and US exceptionalism.
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-19 in China.
The impact of China on EMs (it accounts for one-third of the market capitalisation in most EM benchmark indices), especially recently, deserves special mention. COVID-19 — its rolling lockdowns suffocating economic activity — aside, there have been regulatory crackdowns on its global technology franchises and a housing market implosion, all coalescing to diminish investor appeal. In market terms, it has resulted in seven large index rebalancing events in Chinese indices.
If China’s woes were not enough, two other idiosyncratic events have also wreaked havoc in EMs. First, the cycle did not favour EM sector composition. The three biggest EM sectors at end-2011 were financials, energy, and materials, making up 51 per cent of the index (these same sectors made up 29 per cent of the US index and 39 per cent of the ACWI). Each of these sectors went on to underperform the EM index.
Second, the opportunity cost of investing in EMs 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 past decade. Less US outperformance means a lower opportunity cost of investing in EMs going forward.
There are other factors that suggest cautious optimism about EMs is not misplaced. And I stress caution. To my mind, four things need to occur. First, valuations must be cheap, and valuations are now historically very cheap. US equities are 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.
Second, the US dollar needs to have peaked. Third, the interest rate hiking cycle needs to have concluded. And finally, developed markets must find a bottom. Right now, valuations are cheap, so if the other three factors happen in the first half of this year, then that could be a strong catalyst for a rebound in EMs from extremely oversold levels.
If this macro scenario unfolds, where will the opportunities lie in EMs? One of the things to like about the asset class — which sometimes gets lost in all the noise — is that we have more opportunities to invest than perhaps 10 or 20 years ago, with much higher quality companies and corporate governance improving significantly in places such as Brazil and India.
We also have large new areas to invest in in the Middle East, which is booming given elevated oil prices. Elsewhere in Asia, and very recently in Asia outside China, there are plenty of opportunities for growth, at very discounted valuations.
It goes without saying that all investments carry risk. And whether they be macro or specific to an asset in which the investment strategy invests, all are typically magnified in EMs. That Latin phrase, caveat emptor, never seemed more applicable than when applied to EMs. But for those investors who do, 2023 might just prove the right time to put their toes back in these investment waters.
Archie Hart, portfolio manager for the emerging markets equity strategy, Ninety One