Reassessing Emerging Markets Equities

The case for EM equity investing has traditionally rested on a combination of rationales: in addition to improving portfolio diversification, emerging economies offer greater potential upside than developed countries, and their less efficient markets offer active strategies greater opportunity to exercise skill. Over the past decade, EM equity returns have disappointed investors. Benchmark indexes have trailed developed market (DM) counterparts, especially U.S. equities, and active strategies, generally speaking, have not generated historical levels of outperformance.

In this note, we contextualize these trends and analyze the drivers. We reaffirm our outlook for the asset class, noting that EM’s overall absolute performance does not look abnormal. But we show evidence that a narrow “one-factor bet on growth” is evident in benchmark performance and the cross section of EM stock returns.

As such, we believe that it is especially important for investors to recommit to EM strategies that reflect a diverse set of returns drivers rather than chasing recent performance trends.

Recent EM Performance and Drivers

Perceptions of recent EM equity performance have been distorted by the exceptional strength of the U.S. market. Figure 1 shows that while U.S. stocks have dominated over the past five years, EM has materially outperformed other developed markets. Moreover, on a risk-adjusted basis, recent returns of EM equities have exceeded their longer-term average, and their 20-year performance remains comparable to the U.S.’s, despite the latter’s recent run.

Figure 1: EM Performance versus DM

Through August 2020

Figure 1 also offers a reminder that regional outperformance tends to be transient, emphasizing the evergreen value of geographic diversification to longp-term investors. While U.S. equities outperformed in the mid- to late-1990s, culminating in the TMT bubble, non-U.S. markets generated higher Sharpe Ratios during much of the 2000s, a period fueled by robust, broad-based global growth.

An even longer look back would show that regimes  of dominance, like the one that the U.S. has enjoyed recently, are unusual in terms of their magnitude and duration. Within U.S. equities, for example, since 1926 we have seen only one comparable episode of risk-adjusted performance (Sharpe Ratio above 1) – during the 1950s. Moreover, as we have discussed elsewhere, although large-cap U.S. growth stocks have dominated a wide range of assets in recent years, periods of strong outperformance by one asset class can end abruptly.¹ While it is understandably difficult for EM investors to put aside their frustration with the past underperformance, the key challenge now is to assess the outlook afresh.

That outlook is informed by an understanding of what has been driving EM’s relative performance. In Table 1, we decompose each region’s returns over the past five and twenty years into contributions from fundamentals (cash earnings growth), multiple expansion, currency effects, and dividends.² Two features are telling. First, over the past five years, EM’s underperformance versus the U.S. has been driven by multiple contraction (-0.5% vs. +2.7%), while earnings growth across the two market segments has been fairly similar (+4.8% vs. +5.4%). Looking over time, however, we see that EM has experienced a much larger decline in earnings growth (+4.8% vs. +10.2%) than the U.S. (+5.4% vs. +6.1%).

Table 1: Returns Decomposition

Arithmetic averages, in percent

One interpretation would be that the market has rewarded the relative stability of U.S. earnings growth with multiple expansion, assuming that it will continue. This would be consistent with a view that the U.S. is the peculiar beneficiary of an enduring increase in corporate profitability that other markets, including EM, will struggle to replicate.³

Several arguments caution against simply over-extrapolating the trends of the past five years into  a continuation of U.S. dominance relative to EM in  terms of investment performance. First, the relevant question is not whether U.S. stocks will continue to generate more attractive fundamentals in an absolute sense, but whether the market has come to fairly price  (or overprice) that likelihood. Second, there are potential headwinds to some of the trends that have benefited U.S. large- cap growth, including nationalist backlash against globalization, populist resistance to technological disintermediation of labor, and regulatory pushback on  corporate size and power.

Finally, we see evidence that the market may be underestimating EM’s relative fundamental potential. Notwithstanding the sharp decline in corporate earnings growth, EM economic trends have held up comparatively well.⁴ Figure 2 shows that emerging economies have continued to gain global GDP share, while their (float-adjusted) equity market cap share has continued to lag.⁵ These observations are directly relevant to regional allocation decisions: long-term empirical analysis shows a relationship between economic growth and equity  market returns. (Please see the sidebar for discussion  of this point.) Moreover, in the present context, it is not  clear that looking forward, structural shifts that have predominately benefited the profitability of U.S. large-cap growth stocks, including development of new lower-cost business models, will disproportionately benefit that economy (or DM more generally).

Figure 2: GDP and Public Equity Capitalization Share - EM versus DM

2000-2019

Clarifying the Relationship: Economic Growth vs. Equity Returns

The temporal relationship between equity returns and economic growth is intuitive, yet obscured by timing issues in economic data.* By definition, traditional GDP statistics are trailing indicators, measuring activity over backward-looking periods. In addition, GDP data from national statistics bureaus often lags, in some cases by up to a year. As a result, these conventional metrics result in a poor fit between economic growth and equity returns. Figure 3 illustrates this. Each column represents average one-year returns for countries sorted into quintiles by GDP growth (1 = lowest, 5 = highest). The gray columns are based on GDP as conventionally reported. Viewed through that lens, there appears to be little relationship between growth and equity returns. But if we lead the reported GDP data by two quarters (equivalent to lagging the equity returns), as depicted in the “perfect foresight” dark blue columns, the relationship becomes clear: higher GDP growth is indeed, on average, associated with higher equity returns.

Figure 3: Equity Returns by GDP Growth Quintile

All-country universe, 1990-2019, based on annual country returns and GDP growth

The Market’s One-Factor Bet on Growth: EM Perspective

The past few years have also seen an unusual concentration of performance within benchmark EM equities. Figure 4 demonstrates two facets of this pattern. The left panel shows that in each of the past four full years, the four largest stocks in the MSCI EM index alone have generated 25% to 35% of benchmark returns. The right panel shows that the effective number of stocks in the benchmark, as measured by the Herfindahl-Hirschman Index of concentration, has plunged.⁶ Roughly speaking, while the MSCI EM index nominally still contains around 1,400 constituents, it now behaves like it contains only 60, largely owing to the increasingly top-heavy nature of the index’s weights. By comparison, over most of the past 25 years, the index has behaved like it effectively contained well over 100 stocks.

Closer examination shows that the concentration of the MSCI EM index is not only unusual in its extent, but also in its character. When the index last became highly concentrated, in 2002 during the aftermath of the TMT bubble, a small but diverse set of stocks, including China Telecom, Kookmin Bank, Anglo American, and Samsung, dominated the index and generated more than 20% of its returns.⁷ In comparison, the stocks driving the benchmark’s recent performance have represented a relatively narrow technology-oriented group, the so-called BATTS (Baidu, Alibaba, Taiwan Semiconductor, Tencent, and Samsung).

Figure 4: EM Benchmarks Have Become Highly Concentrated

Figure 5 provides further insight, visualizing performance patterns through the lens of style indexes. The middle panel shows that from 2016-2019, growth, large-cap, and momentum indexes generated positive returns, while value and quality dragged. The left panel shows that the pattern has continued during the COVID crisis.

Figure 5: EM MSCI Factor Index Active Returns

These patterns in EM performance are consistent with the manifestation of the “one-factor bet on growth” discussed above in a handful of EM large-cap stocks. A consequence is that EM strategies that have not been geared to large-cap growth have, in recent years, likely underperformed the EM cap-weighted benchmark. Such strategies would include balanced EM investing approaches that prioritize diversity across types of signals, geographies, and industries as well as strategies with mid- and small-cap orientations, seeking inefficient markets. While it is tempting for investors to chase the past performance of large-cap growth, looking forward we would advocate recommitment to EM strategies that are well diversified. Outperformance of narrow sets of drivers often ends abruptly, and there are risks to trends that have contributed to rising large-cap growth profitability, as discussed in the prior section.

Conclusion

A central challenge facing EM investors is to dispassionately reassess the investing climate following several years of relative underperformance, particularly in comparison to the U.S. Based on close inspection of trends in returns and their drivers, we believe that the case for EM allocations remains sound. Moreover, we would caution investors not to chase recent performance trends, specifically, the exceptional outperformance of a handful of large-cap growth stocks that has left EM benchmarks unusually concentrated. Instead, we would urge recommitment to more durable EM investing approaches that provide exposure to a diverse set of returns drivers, geographies, and industries.