New approach to EM investing

Emerging market equities have held out much promise, but have, for long stretches, not quite delivered. Despite the strong potential of their economies – since 1988 they’ve delivered 4.7 per cent annual GDP growth compared with 2 per cent for developed economies – that hasn’t always translated into equity market performance.

One reason is that emerging markets themselves are heterogenous. But grouping them according to their underlying economic characteristics allows investors to better calibrate their exposure to the asset class, and by doing so should help them improve their returns.

Long cycle rides

Since their introduction as an asset class in 1988, EM equities have marginally outperformed developed markets. But it has been a bumpy ride, with a couple of long cycles in the interim.

From 1988 to 1994, EM stocks sharply outpaced developed equities, thanks in part to the opening of formerly communist countries and an explosion of manufacturing production in Asia. They then underperformed over much of the next decade as the US economy swung into gear, driving with it a tech bubble and a strengthening dollar, which triggered a series of crises in emerging economies with dollar pegs. That all ended with the tech bust and the 9/11 attacks on the US in the early 2000s. The following decade then became EM’s again, only to reverse when interest rates fell to zero in the wake of the global financial crisis.

One of the most salient features of EM in that period was the variability among the asset class’s national equity markets in how they responded to economic factors. Although EM equity markets are significantly more correlated with each other than they are with other asset classes, including developed market equities, there is a high degree of dispersion in the correlation between these same equity markets and macro-economic factors. Managing this dispersion is one way for investors to get the most out of their exposure to EM.

Making sense of EM

Broadly speaking, emerging market economies fall into four divisions: 1) China vs the rest of the emerging universe; 2) commodity exporters vs manufacturing countries; 3) debtors vs creditors; 4) and finally open vs closed economies. 

These divisions help to explain both the cycles of outperformance and underperformance.

Take the first, China vs the rest of EM. While the Chinese economy outstripped the rest of EM since 2008, posting average annual nominal growth in the order of 10 per cent, with similarly strong corporate earnings growth over the same period, earnings per share came in no better than the middle of the pack. Basically, Chinese companies diluted their performance as far as investors were concerned by being heavy issuers of shares, so investors with a heavy weighting in Chinese stocks during the past decade would have lagged.

Then there are the commodity countries. The greater their dependence on selling raw goods, the more volatile their economic growth, compared with manufacturing-based EM countries. As a result, commodity producers’ equity markets traded at a discount to those of manufacturing countries. 

For their part, debtor countries were more vulnerable to movements in US interest rates and in the US dollar. This vulnerability has been manifested in the underperformance of these countries’ equity markets compared with those of EM creditor countries, particularly since the 2013 taper tantrum, when the US Federal Reserve warned that it would be scaling back its asset purchase programme (see Fig. 1). 

And finally, there are the open vs closed economies. Closed economies – excluding China – performed better than open economies during the commodities boom that ran from 2001 to the end of 2007, but then underperformed significantly since.

In a nutshell, investors who had had a lower weighting in China, in commodity countries, in debtor countries and in closed economies during the past decade would have outperformed the EM equity benchmark during the past decade. That’s not likely the be true over the coming years.

A new cycle?

Increasingly, signs suggest emerging market equities are poised to start another upswing relative to developed markets. If history is a guide, this could last a decade or more. Our analytical approach offers an indication of which emerging market economies should benefit most.

This suggests investors should have a greater weighting in China vs the rest of EM; in commodity countries vs manufacturers; in debtors; and in open economies.

China, which dominates the asset class, has been one of the major drivers of its underperformance over the past decade. But China’s equity market and economy could be turning a corner. Beijing is easing back on its interference with certain sectors. The property market appears to be bottoming out and real estate is becoming a less dominant sector, accounting for 8.6 per cent of GDP in 2023 from a peak of 15 per cent in 2014. And corporate management is being encouraged to take more of an interest in shareholder value, which should also slow their tendency to dilute existing shareholders.

At the same time, the dollar’s long period of overvaluation is likely to end once the US Federal Reserve starts to cut rates. Since there’s an inverse correlation between how the dollar and emerging market equities perform, this would be a positive signal for EM, particularly the more open EM economies. Furthermore, signs that world trade is picking up again as economies rebound following Covid and some of the reshoring trend slows, should also support the existing growth premium EM countries have over the developed world (see Fig. 2). 

There are also a number of long-term factors that are likely to support EM equities. For one thing, EM equity markets are deeply undervalued relative to those of the developed world. Re-evaluation of EM’s attractions should spark a revaluation of these markets. At the same time, the global energy transition away from fossil fuels will not only benefit EM producers of necessary commodities like minerals for photovoltaic cells, but also benefit countries closer to the equator and therefore with greater intensity of sunlight. As emerging market economies mature, they also diversify, which should be another stimulus to their equity markets.

EM’s long cycles make investors forget the asset class’s even longer-run attractions – improved risk adjusted returns – during downswings. Understanding that EM is heterogenous and that its economies can be sorted in buckets that perform differently during different macro-economic climates can help to mitigate those downswings and boost performance during the upward leg of the cycle.