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Emerging Market equities
Is now a good time for investors to rethink their allocation?
Teodor Dilov
Investment Consultant
What do we mean by 'Emerging Markets'?
It is a common misconception that Emerging Markets (EM) are dominated by China whose weakening macroeconomic prospects has grabbed headlines in recent years. While it is true that the country played a significant role in the EM growth story for the past two decades, it represents around a quarter of the MSCI Emerging Markets Index. Therefore, there are plenty of opportunities elsewhere such as other East Asian regions which in fact bear a higher proportion of innovation and allow exposure to major themes such as the Artificial Intelligence at a discount to their US-listed peers.
Country weights
Source: MSCI
Emerging Markets now offering higher technology exposure than many developed markets such as continental Europe (c.11%), the UK (c.3%) and Japan (c.17%).
Shifting landscapes
The scale of the Chinese market often makes its 'Emerging Market' label unhelpful in understanding its investment landscape, which unlike most of its peers is increasingly driven by secular characteristics, due to its diversity and high levels of liquidity.
Nevertheless, limited foreign access and a lack of transparency in the market have been serious hurdles for China’s inclusion in the developed markets index.
More recently, a growing trend related to China’s shaken economic outlook is reshoring outside the country, which has seen other regions benefitting, most notably Mexico (which is now the biggest overseas trading partner of the United States), India and other countries in Southeast Asia such as Indonesia, Malaysia, the Philippines, Thailand, and Vietnam, which are collectively known as the 'Tiger Cub Economies'. However, there are some positive factors on China as well. While the country is in transition to more sustainable economic growth with healthier sources of revenue, its companies are trading at historic lows. Therefore, despite its recent underperformance, there are plenty of good opportunities to access quality businesses with strong growth prospects in areas like biotech, consumer and industrials.
Countries like Brazil and Saudi Arabia have strongly benefitted from the increase of commodity prices over the past two years. Although they are generally perceived to be in a disadvantaged position in the transition towards a lower emissions world, the demand for commodities such as hydrocarbon may push prices higher as environmental constraints limit supply. In the case of Saudi Arabia, there is also a massive push for the country to diversify its economy from oil revenues through the Vision 2030 project, which could present opportunities in many areas such as renewables, construction and tourism.
How Has the Emerging Markets Space Evolved?
Emerging Markets have experienced some quite dramatic changes over the years in terms of both regional and sector composition.
While today Asia dominates the index with almost 80%, historically EMEA and Latin America represented nearly 60% of the index in 2001.
Information Technology Exposure
Source: Morningstar
Energy Exposure
Source: Morningstar
From a sector perspective, technology has been steadily growing and currently represents around 22% of the Index, while energy has dropped to just under 6% (down from nearly 30% in its peak during the early 2000s). This resulted in the emerging markets now offering higher technology exposure than many developed markets such as continental Europe (c.11%), the UK (c.3%) and Japan (c.17%).
Information Technology Exposure
Source: Morningstar
Valuations and allocation
Despite all positive signs of recovery coupled with long-term growth prospects, Emerging Markets remain one of the most mispriced areas of the market.
Concerns about the weaker macroeconomic climate in China along with the US interest rate hiking cycle were among the main reasons for the rather negative investor sentiment towards the asset class. Although absolute valuation levels moved higher over the past twelve months, on a relative basis they still seem attractive against developed markets. In fact, the valuations gap has even widened recently and the MSCI EM Index currently trades at around 25% discount to the MSCI World index (and around 30% to the S&P 500).
Global managers allocation to EM
Source: Morningstar
EM representation in the MSCI ACWI
Source: Morningstar
In addition, Emerging Market equities remain under-owned by global investors. Although their representation in the index has recently declined to around 6% of the total market capitalisation in the MSCI All Country World Index (as of February 2024), the average global equity manager currently has around 3.7% exposure to the asset class. Therefore, it could be argued that the market has not fully priced in Emerging Markets’ forecasted share of global growth and economy (currently they contribute almost 60% to the global GDP growth and around one third of global GDP according to IMF’s data), its young population and growing number of consumers and new technological developments.
Inefficient and illiquid?
Being misunderstood and therefore often neglected is what offers investors very attractive opportunities in Emerging Markets.
Many of those stock markets are dominated by domestic retail investors which bring a higher chance of over-reacting relative to their developed market peers. For example, China with its onshore A shares market (where the inflow of foreign capital is restricted and currently represents below 5% of the total ownership) and Saudi Arabia are among the most retail dominated markets in the world. In addition, less publicly available information, varying reporting standards and the chance of foreign investors withdrawing quickly should the economic outlook decline, all contribute to higher inefficiency. While inefficient markets are often illiquid, Emerging Markets still provide solid levels of liquidity, making them very appealing to active investors and stock pickers.
Performance wise, over the past 12 months, the MSCI EM Index has returned 9.4%. The top five contributors were India, Taiwan, South Korea, Brazil and Saudi Arabia, while China and South Africa were lead detractors over the period.
Considering EM remains an overlooked segment of the market it might be a good idea for investors to reassess the opportunities in that market. Rising incomes, urbanisation and government support for economic growth should continue driving a stronger middle class that can spend on products and services that were previously unavailable to them. Adding the attractive valuations and good liquidity all support the case for higher allocation to Emerging Markets.
How to access?
Investors can gain exposure to this part of the market through various products both active and passive.
However, passive approaches tend to be more expensive compared to their developed market peers and often lag in performance as Emerging Markets are inefficient. As an example, over the past 15 years the MSCI Emerging Markets Index has delivered an average return of 8.5% per annum compared to 13.2% for the MSCI World in local currency terms, with both having identical levels of volatility over the same period.
Therefore, active management is expected to thrive in such an environment and be more effective over a full market cycle. This is typically achieved by managers who have strong knowledge of the local market and its features as well as the region’s business and governance culture.
