Since 2009,emerging market equitieshave lagged behind their developed market peers. Why is this the case? And what does it mean for investors going forwards? We look at the story behind the data.
At a glance
- Historically, investors mayhaveexpected emerging market (EM) equities to outperform developed market (DM) equities
- This expectation is based on economic theory and risk-reward: investors want compensation for taking on the risk of investing in EMs
- Since 2009, EM equities have on aggregateunderperformed their developed market peers, forcing investors to revise their expectations, and the theories they are based on
- Company earnings have disappointed, and EMs' greater sensitivity to global macroeconomic forces combined with the structure of their domestic economies has been a headwind to performance
- Going forwards, the outlook for EMs is uncertain, with further challenges on thehorizon
Historically, investors have looked to emerging markets for cheaperbut potentially higherrisk stocks that offer the possibility of greater returns. Why is that? Well, it all rests on the promise of 'convergence'.
Convergence is the idea thatincomes of citizens of emerging economiestend to grow at faster rates than those in richer, more mature economies. Much of this comes down to the potential for faster growth in manufacturing, employment, and money flow from developed markets,all factors which can support the performance of emerging market equities.
Convergencealso rests on theconcept ofdiminishing returns to capital investment. This means that as an investment in a particular area increases, the rate of potential profit from that asset – up to a certain point – cannot also increase. Farmland is the classic analogy here: once you exhaust the land available in a given plot, rather than planting more seeds in the same plot, you’re best going to other plots with plenty of nutrients to increase income.
The same principle here underpins capital inflows toemergingeconomies. The average investor may gain better returns by investing in markets with a lowercapital to labour ratio (the amount of capital available per worker),as the marginal return on capital will behigherwhere the ratiohad a low baseto begin with, compared with the amount of capital available.This should, in theory, enableEM equitiesto outperform their developed market peers.
This returnshouldin theory show up in equity markets as outperformance in emerging markets versus developed markets. On balance, however, investors should require a higher return on EM assets than developed assets due to thehigher risk from factors such as illiquidity (illiquid assets areharderto sell if there arefewerbuyers) and currency volatility (EMcurrenciesare generallydeeplyaffected by strong currencies like theUSdollar,and can be prone to sudden devaluation).
Convergence iswhat we saw with the Asian Tigers (South Korea, Taiwan, Hong Kong, Singapore) in the latter part of the 20thcentury (1), in the Baltics in Europe in the early 2000s (2) and, more importantly, this is reflected in theMSCI Emerging Markets Indexin the 2000s.
Over the past 15 years,this narrative has not played out, leadingsome to re-think the convergence theory. One school ofthinking isthat higher returns can only be realised if there are structural changes to bring emerging market economies in line with moreadvancedeconomies.
But there's more to this story. There appears to be a clear divergence in the fortunes of emerging market economies pre andpost-2010, as demonstrated in the chart below.
Chart 1: Emerging market performance 2002-2024, local currency terms
Source: Macrobond
This tells us the story of underperformancenumerically –but we can go further and examine thesourcesof underperformance, and look at why EMs have struggled over the past 15 years.
We use here theGrinold-Kroner Model.
Very simply, the model allows us to break down returns into components: yield,forward price-to-earnings ratio, repricing, and earnings growth.
- Yield is the return earned by way of dividends orstock buybacks
- The forward price-to-earnings (FW P/E ratio) divides the company's share price by its estimated future earnings per share – and changes in the FW P/E ratio impact repricing (the price of a stock going up or down), driving returns
- Earnings growth (Earnings Per Sharegrowth) reflects the changes, either positive or negative, in how much companies earn each year
The combination of allthreegives a fuller picture ofhow much return is earned, and where it’s coming from. This is even more useful as we can not only look at the differences in returns but we can also identify and isolate exactly which component is contributing to the differences in return between different markets.
Chart 2: Composition of emerging market equity returns, 2009-2024,USD
Source: Macrobond
This breakdown provides a good amount of insight into EM indices as a whole.
We see there’ve been periods of repricing action in the orange bars where forward P/E moves sharply downwards (2013, as an example). Zooming out a bit however, we see one persistent contributor to the underperformance of EM markets: lower earnings growth in the grey bars that appears in the majority of the yearssince 2010.
Looking local: what the performance of different emerging markets tells us
The MSCI Emerging Markets Index comprises 24 emerging markets. Here, we focus on the story of Brazil, India, China, South Korea and Taiwan.
For much of the period, these fivecountriescomprised a chunky65% to 80%of the MSCI Index.
As we'll see, EM equity markets tend to be dominated by sectors and in some cases, individual companies.Over thepast 15 years, this has had a positive and negative impact on their performance.
Generally speaking, EMs are also very sensitiveto the winds of global factors compared with larger, more diversified economies which generate much of their returns domestically.We can explore just how sensitive they are to macroeconomic forces via correlation analysis, which involvescomparing emerging markets to global aggregate indices.While it's important to note that these areexplicitly not determinants of returns,they nevertheless present interesting datapoints as food for thought.
Werun correlationanalysisbelow onsemi-annual returns datafor the indices referred to below. Correlation numbers are interpreted on ascaleof -1 to 1. Correlations oflessthan 0 are negatively correlated, around 0 is no correlation(indicating a low sensitivity to global factors)and greater than 0 is positive correlation(indicating a high sensitivity to global factors).
Do not ignore commodities: BrazilandIndia
Brazil and its equity markets have been incredibly sensitive to shifts in global demand forcommodities (including coffee and sugar). The early 2000s saw a commodities boom unleashed by China’s ascension to the World Trade Organisation. Brazil was a major beneficiary of China's increased demand for commodities (3), with its largest exports shifting from24.6% to the US (in 2001) to 14.7% to China in 2010. Running correlation on an annualised basis, we see a correlation between the Bloomberg Total Return Commodities Index and MSCI Brazil'sEPSgrowth component of returns running at a strong level of 0.68.In the chart below, we see how Brazil's equity indices have moved in line with the commodity market, noting their volatility in recent years.
Chart 4: Performance of commodities and Brazilian equities, 2002-2024, USD
Source: Macrobond
India has also been sensitive to global shifts, but here we look at the correlation data a little differently.Bearing in mindthe cause of its initial slowdown including a hangover from the 2009 globalfinancial crisisand the ensuing growth slow down, a depreciating currency, a return of higher inflation and accompanying higher interest rates. While it's readily accepted by most commentators that the economy of Brazil is intricately linked to commodities, India is much more spoken of in the context of itspharmaceuticalsand information technology sectors.
However, income from agriculture still remains important in any analysis of India, and when we correlate the MSCI India EPS growth each year with the Bloomberg Total Return Commodities index, we see ahigh correlation of 0.58.
The story of India appears to be peeling away from its decade-long narrative in recent times, asinvestors pull back from Chinain search of exposure with less regulatory and geopolitical risk.
TaiwanandSouth Korea: Information Technology is a key driver
Taiwan and South Korea are quite driven by the fortunes of information technology.
At the time of writing, Taiwan Semiconductors (TSMC) is about24%of MSCI Taiwan, and Samsung contributes21%to MSCI South Korea (4).All in, we see a total contribution byInformation Technology (IT)of 61% to MSCI Taiwan and 33% to MSCI South Korea (5). But how much does the global market’s view of information technology actually gets reflected in each economy?
Again, we ran a correlation analysis on the returns of each indexagainstMSCI AC World Information Technology Index, and saw avery moderate correlationof 0.50 for MSCI Taiwan and low correlation of 0.42 for MSCI South Korea (6).This low tomoderatecorrelationmeans that theperformance ofglobal information technologyindices is reflected to some degree in Taiwan and South Korea's local stock indices (7).
China: Materials is important for the scale up of an economy
There’s been much research and analysis carried out in recent years on the importance of a rapidly evolving geopolitical landscape, from the introduction of tariffs, changing domestic and foreign regulatory landscape, to changing internal focus within China.
But, as in the other emergingmarkets, the underperformance of Chinese EPS growth began much earlier,with underperformance beginning in 2011. Since then, China's economy,including its property sector,has facedbattles with inflation, increasing interest rates, a change in focus from export-oriented output togrowth led by domesticdemandtoo, and most recently, an embattled real estate sector.
We, however, lookfor insight into China’s equity markets via sector-based analysis. China’s growth story cannot be separated from its materials and accordingly, we see a strong correlation of0.52between MSCI AC World Materialsand MSCI China EPS growth. Materials and China are closely linked, as materials act as the fuel powering the growth of other sectors, including infrastructure, industry and real estate. This serves as a reminder that however damaging the impact of thepropertycrisis in China, investors should look beyonditto examine the knock on effects on other sectors. It's also worthwhile to not only look at theinternalfactors affecting its domestic economy but external and global factors as well.
What is the outlook for emerging markets?
Emerging markets are clearly a diverse group, with very many factors and drivers influencing their economies and their equity markets.
There are some notable headwinds ahead for the major emerging economies. First, agoodbye, perhaps, to the global low interest rates regime we saw post-2009. Second, the reduction in demographic advantages as economies stop growing, third,a slowdown in institutional reforms that lead to convergenceand finally, the ever present geopolitical risk and the influence of external variables like the US Dollar.There are alsopotential tailwinds: the global green transition thatcoulddrive demand for greencommodities andmaterials, boost information technology and change the nature of demand fundamentally.
We’ll round off returning to the original premise therefore with the recognition thatconvergenceand the realisation of a higher equity market return (as a result of a higher relative marginal return to capital) isn’t a straightforward path.
Global headwinds, as well as domestic equity market dynamics, can temporarily derail the journey.We continue to monitor the investment case for emerging markets, and we maintain an underweight position in our portfolios.
Sources
(1) https://en.wikipedia.org/wiki/Four_Asian_Tigers
(3) https://oec.world/en/profile/country/bra?yearSelector1=2001
(4, 5) Bloomberg
(6) The US constitutes the largest country allocation to the Information Technology Index at 88.46% as of Dec 2023https://www.msci.com/documents/10199/69aaf9fd-d91d-4505-a877-4b1ad70ee855
(7) MSCI ACWI - annual returns of 51.5% 2023, MSCI Taiwan - annual returns of 31.33% in 2023 -https://www.msci.com/documents/10199/6f36d84d-425d-4e1f-8d56-e65c455ebda1,https://www.msci.com/documents/10199/aa4a6b46-4e72-45af-8d1b-5c8f00459666
All correlation data is from Macrobond.
Risk warning
Emerging markets are riskier than developed markets because they can experience political instability, illiquidity and currency volatility, and a high level of state-owned or state-run enterprise and are not suitable for all investors.As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance and simulated past performance are not a reliable indicator of future performance. Forecasts are not a reliable indicator of future performance.
