Views and Analysis

Seven reasons to invest in Emerging Markets now !

Global Emerging Markets Equities have lagged Global Equities for the past five years. However the year-to-date performance of GEM and Asia ex-Japan has been very strong, outperforming the global index, the US and most of Europe.

Rationale for investing:

There are 7 reasons why we believe that investors should reconsider their positioning in GEM equities and seriously contemplate being overweight GEM equities.  

1)      Emerging markets do not have a monopoly on political risk.  There is a heightened level of geopolitical risk in both emerging and developed markets.  Political risk can no longer be used as a valid reason to underweight GEM while remaining overweight developed market equities.

2)      Studies have repeatedly shown that there is no correlation between GDP growth and stock market returns.  Nevertheless GDP growth in GEM is improving due to the strengthening BRIC markets, which together account for almost 50% of GEM.  Brazil and Russia have recently exited deep recessions, while India and China continue to exhibit stable growth.  Meanwhile South Korea and Taiwan, which together represent an additional 25%+ of the GEM index, are benefiting from an improvement in exports.  Hence the strengthening economic picture in GEM is creating a conducive environment for GEM companies to flourish.

3)      From a bottom-up perspective, GEM companies are showing improving trends.  For the first time in years the ROE of GEM companies is higher than the ROE of developed market companies.  Meanwhile GEM companies are enjoying positive earnings revisions.  Normally the Street is too bullish at the start of the year and has to cut forecasts as the year progresses. This year began with analysts being too cautious and are now being forced to revise up their earnings forecasts.

4)      Valuations are relative very attractive.  On a 12 month forward p/e basis GEM trades at a 25% discount to global equities and more than 30% discount to US equities.  This is despite GEM eps growth forecasts being almost twice as high as global and US earnings forecasts. 

5)      Some investors have been concerned that the US dollar would strengthen as the Fed hikes interest rates.  However US economic data is surprisingly negative which reduces the chance of the Fed hiking aggressively.  In fact according to Bloomberg consensus data there is less than a 50% probability that the Fed hikes between now and the end of 2017.  Even if the Fed does hike rates aggressively, the risk of disruption to GEM currency markets is lower than during the taper tantrum of 2013 as GEM countries typically have strong current account surpluses and rising FX reserves.

6)      GEM accounts for approximately 12% of the MSCI world index and investors are around 4% underweight.  Investors have not been this underweight in GEM equities for about 5 years.  Meanwhile flows into GEM equities have recently started to improve. 

7)      There are structural trends supporting GEM equities:

  • It is worth remembering the familiar structural trends with GEM. E.g. GEM accounts for approx. 80% of the world’s population, almost 60% of the world’s economy and the GEM middle class is growing rapidly.
  • It is important to appreciate that GEM should not be considered as a simple play on commodities.  In fact energy and material stocks account for only 7% of the index each.  The GEM universe is actually much more of a play on global technology as the largest sector in the MSCI GEM index is now technology with a 25% weighting.
  • There are many exciting structural growth trends in technology which we believe GEM companies will benefit from.  These trends relate to smartphones, augmented reality, virtual reality, Internet of things, artificial intelligence, electronic vehicles and autonomous vehicles.

Conclusion:

We believe we are at an inflection point in GEM equities.  Over the past few years investors have made strong returns in developed market equities while being underweight emerging markets.  GEM is now trading at a huge 25% discount to developed markets and GEM earnings continue to be revised up.  Investors have not been this underweight GEM in about 5 years and inflows into GEM equities have started to return.  There is scope for these inflows to continue as the flows YTD only account for a fraction of the outflows over the past few years.  Finally it is worth remembering that the balance of economic power is shifting away from developed markets towards emerging markets.  At the same time technology, which is the largest sector in GEM, is an exciting area to focus on given structural trends in areas such as smart phones, augmented & virtual reality, Internet of Things, artificial intelligence and electric & autonomous vehicles.

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Daniel Tubbs