Emerging market (EM) equities are underperforming for a second year, down -16.4% year-to-date after last year’s -2.2%. This has brought back the question of whether investing in EM equities still makes sense? Over a 10-15 year time horizon, EM is the region where we identify the highest return potential given faster potential revenue growth, potentially offering 280bps of additional annual returns over the U.S. However, as is often the case with EM, sentiment swings can drag on returns in the short-term. Three main reasons may lead to a turnaround in EM performance: 1) positive orientation of certain EM markets to higher commodity prices, 2) potential turnaround in sentiment towards China’s economy and markets, and 3) discounted valuations versus the U.S. in an environment where valuations matter again. EM equity is an asset class that is too important to ignore, but nearly half of portfolios we analyze do not contain an allocation to an EM manager. Given the asset class’ higher volatility, selecting managers with certain batting averages and/or capture ratios can help make the asset class more palatable.

Sentiment has dragged on EM returns this year, with multiples down 9% and currencies weaker by 2%. Higher volatility due to geopolitical conflict, growth softness in China, and a quick repricing of central bank tightening expectations have not helped, but these three variables could end up being potential tailwinds for EM returns:

1. Higher commodity prices benefit some EM markets that have a large orientation towards the energy and materials sectors, including Latin America and the Middle East and Africa. Commodities represent about 20% of these previously unloved markets, leading to double-digit positive returns year-to-date. The conflict in Ukraine will likely pose a substantial challenge to the 1.6% of the index represented by Eastern Europe (with Russia now excluded from the index).
   
   
2. A turnaround in sentiment towards China may soon be in the cards, a direct benefit to 35% of the EM index now represented by Chinese markets and an indirect benefit for the remainder. China’s 5.5% GDP target for 2022 may be achieved should China utilize the room it has in monetary and fiscal policy. In addition to economic stability, China is now focusing on market stability, with the announcement phase of the regulatory cycle potentially winding down soon.
   
   
3. Higher U.S. rates should refocus investor attention on valuations. EM’s 40% discount to the U.S. is particularly large versus its normal 30% discount. In a world of rising yields, investors have started to take starting valuations into account once again. A turnaround in sentiment towards China may soon be in the cards.
   
   

Emerging Market Equities are an asset class too important to ignore; however, based on thousands of financial advisor portfolios reviewed by the J.P. Morgan Asset Management Portfolio Insights team, 47% of portfolios analyzed in February do not contain an allocation to an EM manager. Of those that do, the average allocation to EM is 7.5-8% of total equities, a bit below a 10% neutral allocation. When allocating to EM, we also cannot ignore the associated volatility.  For instance, the MSCI EM benchmark has provided an annualized volatility in excess of 16.5 over the past 5 years.  Combine that with over 600bps annualized performance difference between top & bottom decile investments within the Diversified Emerging Markets Morningstar fund category over that same timeframe, and the importance of investment selection suddenly becomes quite clear.  In addition to traditional metrics used to assess a strategy, we are also fans of utilizing some lesser known measures in this space.  Batting average is an excellent statistic to help gain clarity on consistency; measuring how frequently a strategy is able to meet or beat a benchmark.  Additionally, not all volatility is bad.  Up & down capture ratios are a great measure to help further understand the overall volatility as they explain how much a strategy has participated in both up and down markets.  Finding strategies with high batting averages and/or capture ratios that mirror characteristics you are looking for within the asset class can help make these volatile areas of the portfolio more palatable for clients.

Both value and growth areas in EM may see tailwinds
Sectors as % of index market capitalization

Source: FactSet, MSCI, J.P. Morgan Asset Management. Data are as of March 16, 2022.