ADRIAN CLAYTON: A tidal turn on horizon for emerging markets

I would like to suggest the unthinkable: emerging market indices could be on the verge of outperforming developed markets. 

The MSCI Emerging Market Index (MSCI EM) outperformed the MSCI World Index (in effect a developed markets index) from 2000, but underperformed over 20 years and has been awful in the past decade, returning a paltry 10% versus more than 100% for the MSCI World Index.  

Severe emerging market underperformance started after these stock markets hit their zenith in November 2007, one month before the official onset of the global financial crisis, and they have never fully recovered though they did flirt with new highs in 2021 before subsequently wilting. 

But every dog has its day, so what will it take for emerging markets to rebound?  The answer lies in dollar weakness and earnings growth.   

Dollar weakness 

With respect to emerging market performance, since 1998 there are really two distinct periods to consider. The decade 1998-2008 was a period of supercharged gains, and this was followed by more than a decade of underperformance. It is no coincidence that both periods correspond perfectly with dollar movements — weakness in the first period, followed by a long and bumpy run of extreme dollar strength in the second, as illustrated by the accompanying graph. 

There are numerous reasons why a weaker dollar propels emerging markets, but this article demands brevity so we will cover the two main ones. First, emerging markets that have dollar debt benefit when the dollar weakens due to lower interest and capital repayments: manufacturing-based emerging markets have many of their input costs priced in dollars, so dollar weakness allows them to buy more of the same product per unit of dollar, which allows them to leverage their scale advantages profitably.   

The dollar’s strength over the past couple of years is ascribable to the US’s exceptional growth story, a “flight to safety”, and aggressive interest rate increases from the Federal Reserve. We believe many of these vectors have now run their course. A future world with a relatively weaker dollar should surprise few. 

Earnings growth 

The other key to emerging markets outperforming is relative corporate profitability versus developed markets. The graph illustrates this beautifully. From 2000 to early 2010 emerging market earnings growth was higher than that of developed markets, and emerging markets responded with a huge run-up that ended in late 2007, only to experience another leg up, which failed in mid-2010.

But can emerging markets produce elevated profitability again?  Sentiment is overwhelmingly negative against this investment class: news flow is dominated by geopolitical tensions, trade wrestles with the West, and fears of hyper-indebtedness by governments and consumers. None of this can be disputed, yet analysts are upgrading one-, two- and three-year earnings forecasts for emerging markets relative to their larger developed market peers. 

A blunt indicator of valuation is the price-earnings ratio, and while it certainly does not adequately deal with all the nuances on valuation it does tell a story. The MSCI World Index trades at a lofty premium of 26% to the MSCI EM, which is not far off the average premium that has existed since 2011.  The earnings upgrades by emerging market analysts should, given time, be reflected in a lower developed market premium.    

What could upend this thesis? 

Two factors must be closely monitored. The first is an unexpected and severe contraction in global growth. While emerging markets will in time weather this, the immediate outcome will be to postpone their rebound. The second is an escalation in the breadth and depth of the Middle East conflict where it draws in a wider range of countries. Again, this is in our opinion still a relatively low probability outcome and is more likely to lead to a postponement of emerging market gains than negate them altogether.   

As an active manager we believe heightened differentiated stock pricing exists in markets at this stage in the cycle, which lends itself to stock selection. However, emerging markets can be accessed through exchange traded funds, and it is useful to be armed with information on what you would be buying if, say, you bought into an emerging market tracker such as the MSCI EM index. 

This index includes 24 emerging market countries and more than 1,400 stocks. The largest country weights are China (30%), India (16%) and Taiwan (15%). The largest industry groups include financials (22%), information technology (21%) and consumer discretionary (14%). The four most significant stock positions are all technology plays, accounting for 16% of the index.  

For beleaguered investors stuck in emerging market funds your time for reprieve could be drawing near. This includes SA investors; it is true that our market has been a victim of own goals due to our sociopolitical and economic failures, but the JSE has also been shunned through association — with all emerging markets. When this tide turns, it will do so for all small boats. 

• Clayton is chief investment officer at NorthStar.