Can emerging market equities outperform in the next decade?

The early part of the 21st century saw emerging markets outperform.

Having survived a number of currency crisis in the late 1990s, the noughties were a time of stabilisation and growth for these areas.

In fact, while developed markets recovered from the tech bubble and then slid towards the sub-prime disaster that was the great financial crisis, emerging markets returned over 240%* in the first ten years of the new millennium. In contrast, the FTSE All-Share turned just over 25%* and the S&P 500 made a loss of 12%*

Then everything changed. A decade of easy monetary policy meant the US stock market was really the only show in town. Since the start of 2010 to date, the S&P 500 has returned just shy of 493%** compared with 149%** from the UK stock market and 92% for emerging markets**.

But now the investment environment has changed once again, is there reason to think emerging markets could excite investors once again? Could past performance be repeated?

How emerging markets have changed in the past decade

Over the past decade, the composition of emerging markets have changed significantly. Where South Africa once dominated, China has risen. Brazil and South Korea have fallen in prominence while Taiwan and India have grown***.

Sectors have also changed. Energy, materials and communication services sectors have all seen their market share decrease, while information technology in particular has flourished***.

And stock picking in this asset class has become key, as the number of companies in the MSCI Emerging Market index has ballooned by almost 50%. The index is now home to 1239 constituents***.

_{Graphic 1: Emerging Markets have changed in the last decade****}

^{Graphic 2: Technology now dominates the EM index****}

The attraction of emerging markets today

Developing economies have always been a growth story, and that has not changed.

They make up 45% of the global economy (vs 38% in 2012)*** and are experiencing population growth of 1% per annum compared with just 0.2% in developed markets***.

Today, the environment could be far more favourable for this area of investment – peaking interest rates, a weaker dollar, falling energy prices, and a more normalised economy in China, could bode well for the asset class in 2023. And, while it may take some time for these dynamics to play out, there could be good reason to be optimistic.

Fund managers around the world seem to be of this view. According to the latest Global Fund Manager survey by the Bank of America, their allocation to US equities collapsed in January, with respondents stating that their net underweight in the asset class stood at 39%, the lowest since October 2005 (52%). Instead, professional investors reallocated towards emerging market stocks, increasing their net overweight to 26% – the highest since June 2021.

What the fund managers are saying

Daniel Hurley, portfolio specialist at T. Rowe Price, believes there are several factors that should see a strong period of relative performance for emerging markets going forward.

“Valuations are highly compelling relative to developed markets, that, combined with China re-reopening, earnings momentum and the US dollar falling, could see a sustained period of outperformance,” he said.

“China re-opening is clearly the biggest catalyst after almost 3 years of pandemic restrictions; this will be very supportive for the consumer sector domestically also the asset class globally.

It will also be supportive for earnings momentum; emerging markets had the painful reset of earnings in 2022 and should inflect from a low base, this contrasts with markets where earnings have yet to reset and will be of key focus going forward.

“Finally, with the US economy weakening, the dollar could continue to depreciate from high levels. This is supportive for emerging markets; importers will benefit from the falling price of dollar priced imports and countries with dollar-denominated debt loads will also benefit from some respite.”

Tim Love, investment director, at GAM describes emerging market valuations as being, “like a coiled spring,” and says there could be a number of catalysts that spark material up-side for investors.

“15 years of choppy sideways performance is comparable to compressing a coiled spring,” he said. “A series of positive risk return opportunities are now in place (market downturn/Covid/oil shock), which rhyme with the situation in 2003-2008 (post Asian crises/SARS). Light liquidity, low positioning and negative sentiment could drive an attractive prospective risk/return for EM equities in 2023, in our view. Playing defence is yesterday’s game.”

Rob Brewis, co-manager of the Aubrey Global Emerging Markets Opportunities fund, adds that while there is inevitably some de-risking underway in global supply chains as manufacturers seek to diversify their production away from China, “this is all turning up in India (viz Apple’s vast new phone-making cluster outside Chennai), Vietnam, Mexico, and Indonesia to name a few.” In other words, it is very positive for most emerging markets.

“With one or two notable exceptions, the latter part of 2022 has been a period of weakening commodity prices. For most emerging market consumers, this is very good news,” continued Rob. “The changing energy landscape is also a long-term positive for most emerging markets. India is the standout winner in this, being short oil and long solar, at least in terms of potential. Russia, to which we have had no exposure in recent years, is the standout loser.

“Perhaps the final positive for emerging markets is US monetary policy. Whether US rates are near a peak is open to debate, but there are signs that the dollar strength might at least be abating, which makes it much more comfortable for emerging market central banks.”

“Whether it is the formalisation of the Indian economy, the continued financialisation of the South African population or the growing adoption of enterprise resource planning software in Brazil, there are plenty of growth opportunities to tap into,” concludes Rasmus Nemmoe, manager of FSSA Global Emerging Markets Focus.

Five emerging market equity funds to consider

Investors considering emerging markets could consider the following Elite Rated and Radar funds:

Aubrey Global Emerging Markets Opportunities invests in companies offering products and services to the upwardly mobile, ambitious, and aspirational population centres in emerging markets which account for over 70% of the world’s growth.

Federated Hermes Global Emerging Markets SMID Equity is a concentrated fund focusing on small and medium-sized companies across global emerging markets. It can also invest in frontier markets should opportunities arise.

FSSA Global Emerging Markets Focus fund invests in 40-45 large and medium-sized companies in emerging markets. Manager Rasmus Nemmoe has an absolute return mindset and looks for quality companies that can demonstrate sustained and predictable growth over the long-term.

GQG Partners Emerging Markets Equity is a concentrated portfolio of high quality companies with durable earnings. The emphasis is on future quality, rather than companies which have simply done well historically.

JPM Emerging Markets Investment Trust has an established long-term track record of investing in emerging market equities. The extensive team at JPM take a long-term approach and focus exclusively on companies, rather than countries, in the emerging markets space.

*Source: FE fundinfo, total returns in sterling, 31 December 1999 to 31 December 2009

**Source: FE fundinfo, total returns in sterling, 31 December 2009 to 3 February 2023

***Source: Alquity, October 2022

****Source: Alquity, Bloomberg, October 2022

_{Photo by Joshua J. Cotten on Unsplash}