Emerging markets are cheap. The problem is, they’ve been cheap for most of the last decade, and have failed to deliver on their promise.
Over the past 10 years, the disparate collection of 24 countries bundled into “EM”, which range across Southeast Asia to South America, Africa, Eastern Europe, and the Middle East, has returned a fairly pedestrian 5 per cent per year. Over the same period, Australian shares have returned 8 per cent and global developed markets (ex-Australia) 13 per cent – see chart 1.
Not only that, but investors in emerging markets had to strap in for a bumpier ride. The range of the best to worst performing countries in the index averaged an 88 per cent gap over the past 11 years, way more than double the gap in the developed markets.
However, there have been times in the past when the emerging markets have trounced their developed counterparts: between 2000-2010, they notched up returns of 19 per cent per year, while the developed markets could barely scrape 5 per cent. So when they’re good, they’re very, very good.
How do the emerging markets shape up now? The typical long-term arguments for investing in the emerging markets revolve around demographics and GDP growth.
They are home to 87 per cent of the world’s population, including 77 per cent of the “Gen Z” contingent, with the fastest growing middle class, presumably all hankering for the usual consumer goods that go with it. Plus, they’ve driven 67 per cent of global GDP growth over the past decade and are forecast to account for about 60 per cent of total GDP by 2026, yet their combined share markets only represent 13 per cent of the market capitalization of international equities. You can almost see the blue sky.
The problem comes back to a financial truism: share markets are not necessarily representative of economies, in other words, strong economic growth does not necessarily result in strong share market returns. For example, Aoris Investment Management calculated that while the “BRICS” economies (Brazil, Russia, India, China, South Africa – once the hottest market grouping in the world) boasted exceptionally high annual average real GDP growth over the 10 years to 2018, average real corporate earnings growth actually fell by a whopping 9 per cent per year. So while the economies were almost doubling in size over those 10 years, earnings per share fell by more than 60 percent.
In the near term, the emerging markets do look cheap, especially compared to the United States. According to Refinitiv, the emerging markets are trading on a forward price to earnings ratio (so looking at the next 12 months) of 12x, which is a chunky 37 per cent discount to the US’s 19x. However, over the past 35 years the EM index has traded at an average discount of 20 per cent to the developed markets, and while it’s currently around 30 per cent, that’s where it’s hovered for more than a decade – see chart 2.
Why the discount? First, there’s the inability of emerging markets companies to leverage high GDP growth into high earnings growth. Second, there’s the historical volatility compared to the developed markets. Third, the financial, energy and materials sectors make up 35 per cent of the EM index, and they normally trade on low PE ratios. To be fair, IT makes up 20 per cent of the index and includes some household names like Samsung, Taiwan Semiconductor, Tencent and Alibaba.
Zenith Investment Partners expect the emerging markets to deliver 11 per cent returns over the next 12 months based on a ‘soft landing’ scenario, that is, no recession. That compares to the US’s 7 per cent, the developed markets ex the US at 8 per cent, and Australia at 7. A lot of that premium is due to the relatively low PE ratio.
One factor that is always prominent for the emerging markets is the US dollar. When the USD is strong, like it has been over the last couple of years, the EM index struggles. Good luck trying to guess if the USD is going to get stronger or weaker over the next year or two.
Finally, the 600 pound gorilla in the emerging markets is, of course, China, which currently has a weighting of 31 per cent in the index, but accounts for 49 per cent of both EM GDP and stock market capitalization. At the moment, the index includes only one-fifth of China’s A shares, but it’s been rising over time.
It’s easy to argue what happens to China has an outsized influence on the EM index, and for now it’s a guessing game whether the government will step in to support the economy in a more meaningful way. There are many reasons to avoid China right now, but with a forward PE of only 11x, maybe they’re all priced in.
There’s no doubt emerging markets look cheap and have a role to play in a diversified portfolio, but smart investors need to be aware of the risks and shape their portfolio allocation accordingly.