Can fast-growing markets deliver investors more?
However, globalisation means DM companies are operating in EM markets, boosting the growth potential of DM stocks – notably US tech stocks. EM equity as an asset class has not structurally outperformed over time.
EM equity has been correlated to commodities for many years, but changes in China could see this change.
Look beneath past behaviours and correlations between EM vs DM and look ahead for structural changes when considering the benefits of including EM equities in a long-term investment portfolio.
Favouring emerging market (EM) equity has often been regarded as a “no-brainer” for long-term investors seeking high growth, given the view that accessing faster-growing regions of the world should yield higher growth in returns.
Developed markets (DMs) on the other hand, could arguably have reached a growth plateau, as their lower GDP trajectory offers investors limited opportunity to truly enhance returns. A closer look at this hypothesis indicates it is not that simple.
Emerging Markets vs Developed Markets
EM equity as an asset class grew in prominence in the late 1980s, with the MSCI EM benchmark index formed in January 1988. Figure 1 below charts MSCI EM versus MSCI DM equity since inception. It is clear that the relative performance has been cyclical, not structural – at least so far. To further complicate matters, these cycles have not coincided with the global economic cycle. As is often the case with investments, we lack enough data (this example reflects only two cycles) to form robust statistical conclusions on what drives EM equity’s relative performance.
Markets reflect the earning potential of the underlying stocks in the index, rather than geographical GDP growth. The two episodes of DM equity outperformance – in the late 1990s and from 2011 to date – were driven by the strong performance of mainly US technology stocks, which are US-domiciled stocks that are in essence global. For example, there are 2.8 billion daily users of Facebook, WhatsApp, Instagram and other apps owned by Meta (formerly Facebook). It is a global company operating in many emerging markets, listed in the US and therefore included in the MSCI DM index. The same applies to Apple, Alphabet (Google), Microsoft, Amazon, Netflix, etc.
The two episodes of EM equity outperformance were different. The first was driven by a rush of capital into the (then) new growth promise of EMs, fuelled by the collapse of the Japanese bubble and US recession in 1990. This ended with a series of EM currency crises, representing the first widespread EM risk flag to DM investors.
The EM boom of the 2000s was driven by China’s incredible infrastructure activity, creating a rising tide that lifted the boats of many other emerging commodity-producing countries. This was the only period when structurally-higher EM growth manifested in EM equity outperformance.
Meanwhile, as companies have globalised, both the timing of earnings peaks and troughs across both DMs and EMs, as well as profitability levels, have converged – see Figure 2. There seems to be less diversification on offer.
EMs typically perform in commodity cycles… or do they?
Today, China makes up approximately 35% of the MSCI EM index, with Taiwan comprising an additional 15%. In both the East and West, protectionism, socialism and environmental concerns are driving politics away from the laissez-faire approach that resulted in corporate globalisation and profit convergence.
As my colleague, Warren Buhai, recently pointed out in his article, EM equity has typically been well-correlated to the commodity cycle, especially industrial commodities – see Figure 3. But that correlation was almost non-existent for the 15 years from 1988 to 2002. The high correlations from 2002 to 2020 make logical sense to us, as Warren discussed. However, investors buying EM equity this year on that commodity price thesis would have been horribly wrong.
So what happened this year?
We think multiple trends coincided, similar to when individual small waves in the ocean combine to form a much larger wave. These waves were:
- The steady but sure rise of Xi Jinping preparing to be Chinese president for life
- East-West protectionism as personified by Donald Trump
- Structural under-investment in fossil fuel capacity, reflecting the global ESG zeitgeist, and
- Global supply/demand imbalances at the intersection of COVID-induced bottlenecks and loose fiscal policy.
The first two issues have influenced the Chinese trajectory to the downside, while the latter two have squeezed commodity prices higher, hence the dislocation seen this year.
The bottom line is that, this year, China focused aggressively inwardly just as commodity prices skyrocketed. The Chinese Communist Party and President Xi Jinping in particular have flexed their muscles in more actively directing their economy. The old model of excessive gearing – especially in the property sector – for the enrichment of a few is over. What replaces it as their new growth vector is unknown.
Where to from here?
EM equity is not a geared or high beta play on global equity. EM equity as an asset class has not structurally outperformed over time, as many leading DM-domiciled companies operate globally. EM equity has spent many years correlated to commodities, but we appear to be at the early stages of a new Chinese growth model, driven by the imperatives of ‘common prosperity’ and the determination of the (probably) president for life. The Chinese cannot change the structure of their economy overnight, so we would expect the correlation to commodities to reassert after the current adjustment period, but then possibly fade over time as new growth vectors emerge.
When constructing portfolios we consider both prospective returns from and correlations between asset classes with SA markets still dancing to the commodity tune.
The inclusion of EM equity in a typical Regulation 28-compliant portfolio has been more about enhancing returns than reducing risk.
The key EM equity call going forward hinges on one’s reading of China. Aside from the Naspers-Tencent link, to the extent that China becomes more insular, investing there may actually offer better diversification than it has in the past. But that could be some way off.
Tactically, we prefer DM to EM equity, as we currently have a better understanding of growth and policy (both monetary and fiscal) dynamics in the West. EMs may well deliver better tactical returns, but we do not favour that risk-reward prospect as President Xi Jinping looks to cement his grip on power over the next year. Certainly, this view will evolve as Chinese growth and policy pain points become clearer.