Portfolio Discussions: Emerging markets
Economic growth in emerging markets (EM) has been almost double that of developed markets (DM) over the past decade. However, a steep decline in commodity prices and volatile currencies left emerging markets under pressure from 2011 to 2015. After two years of strong performance, EM assets have come under renewed pressure in 2018. Investors should remember that the structural and cyclical stories for EM remain positive. Nevertheless, investors should look to actively differentiate within the asset class to capture opportunities and avoid pitfalls.
The structural case for EM is alive and well
- It is the EM consumer that is expected to emerge rather than these countries themselves. The middle class has gone from representing 0% of populations in India and China in 1994 to 12% and 30%, respectively, today. Over the next 20 years, this number is set to grow to over 70% in many EM countries.
- In addition, long-term growth and return prospects are muted for developed markets, while they are much higher for EM. From 2011 to 2015, this growth differential was shrinking as EM was battered by many storms, but starting in 2016 this gap has begun to widen again as the clouds have begun to part. Long-term, we expect EM to provide a 300 basis point economic growth bump relative to DM.
The cyclical EM story is also not over
- The economic rebound in EM since 2016 continues to feed through to very strong results for EM companies, with double-digit earnings growth last year. Over the next twelve months, earnings are expected to grow by 19% in local currency terms.
- Across the main regions, EM equity valuations are one of the more attractive options. The price-to-book ratio for EM equities currently sits a bit below its long-run average.
- However, investing in EM still requires a selective approach, as the economic, earnings, and valuation picture for regions and individual countries can vary greatly.
Not the same EM
- The prospect of higher U.S. growth and inflation over the next few years has put pressure on U.S. yields and the U.S. dollar, renewing concerns about stability in EM.
- Investors should remember that EM is now in a much better position to deal with these twin headwinds, particularly relative to a few years ago.
- The most vulnerable EM countries have significantly improved their current account deficits, making them less exposed to capital outflows. In addition, EM countries now have much less debt denominated in U.S. dollars.
- EM economic growth and asset performance had been improving since 2016; however, this year’s return of a strong U.S. dollar has put renewed pressure on the asset class.
- Investors should remember that the structural case of the EM consumer and higher return potential remains alive and well, and that the cyclical picture is also still positive given improving earnings and attractive valuations.
- Nevertheless, investors should expect a bumpy ride from this historically volatile asset class, and make sure to differentiate among various EM opportunities.
Focusing on different asset classes or regions, Portfolio Discussions help to frame investment conversations using slides from the Guide to the Markets.
International investing bears greater risk due to social, economic, regulatory and political instability in countries in "emerging markets." This makes emerging market securities more volatile and less liquid developed market securities.
Changes in exchange rates and differences in accounting and taxation policies outside the U.S. can also affect returns.
The prices of equity securities are sensitive to a wide range of factors, from economic to company-specific news, and can fluctuate rapidly and unpredictably, causing an investment to decrease in value.
Diversification does not guarantee investment returns and does not eliminate the risk of loss. Diversification among investment options and asset classes may help to reduce overall volatility.