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Sure Bet Against Emerging Markets

Friday, August 11, 2017
by Ric Palombi

An old adage in investing says that investors hate uncertainty. The corollary is, of course, that investors love, and will pay up for, certainty. In the investing world, nothing has been more of a sure thing than betting that the Emerging Markets (EM) will underperform. In fact, we show in Figure 1, EM have underperformed the Developed Markets (DM) six consecutive years going back to 2010.

Figure 1: Emerging Markets are Beginning to Recover

Source: MSCI, Datastream, Morgan Stanley Research

After delivering persistently weak returns in 2013, 2014, and 2015, many investors have abandoned EM equities.  We believe the tide has turned and the EM is poised to outperform, and below we outline three key supporting factors.

1. Valuation (in other words, it’s cheap!)
The EM trades at an average discount of approximately 15% (Figure 2). Today, the discount sits at 31% - a HUGE discount to their value. We expect this gap to close over time – see point 2!

Figure 2: MSCI EM vs. Developed World – Consensus 12-month Forward Price-to-Book Value

Source: IBES, Datastream, Morgan Stanley Research

2. Healthy Earnings Growth (growth that we haven’t seen since 2010!)
To support the case of EM earnings growth, we show two figures. Figure 3 shows the earnings growth trending negatively until the beginning of 2016. Since then, we are seeing a healthy positive trend in earnings per share growth. In addition, for the first time since 2010, the earnings revision ratio (ERR) for the EM has been trending positive. This bodes well for strong future earnings growth, which is currently not being appreciated by investors.

Figure 3: MSCI EM – Last 12-month EPS Growth

Source: MSCI, Datastream, Morgan Stanley Research

Figure 4: MSCI EM – Earnings Revisions Ratio

Note: Monthly Data since 1988, Earnings Revisions Ration = (no. of estimates upgraded – no. of estimates downgraded) / total number of estimates)

Source: IBES, Datastream, Morgan Stanley Research

3. Inflection Point (now is the time for the tide to turn!)
Inflection points are difficult to identify until after the fact, but are very powerful for those who do identify them beforehand. We believe that the EM are at an inflection point in terms of their return on equity (ROE).

We have spoken at length on our belief of the structural aspect to EM growth as it shifts from cyclical, hard-to-predict commodity plays. China is a poster child for this shift from export-driven to domestic -driven as we are beginning to see more GDP growth driven by consumer spending by more mature and stable middle-income earners. China’s GDP per capita has recently been reported at over USD$8,000, a big improvement from the USD$2,700 a decade ago (source: World Bank). Yet private consumption only makes up 38% of GDP, the lowest among the EM economies (India leads with 59%). This impacts the earnings power and valuation of our companies that are leveraged to the Chinese economy. There is more room for growth and profitability of these companies, and we believe the improvement on ROE going forward is sustainable. 

 Figure 5: MSCI EM – Trailing Return on Equity

Source: MSCI, Morgan Stanley Research

As we have provided support for a sustainable positive trend in the emerging markets, we caution that investors do not operate on the belief that all emerging markets are created equal. The emerging market label covers a wide range of economies and countries, which have different drivers and their own set of unique opportunities and risks. Opportunities in EM are compelling but investors must take care to properly position their portfolio to achieve optimal risk/reward. In order to control risk and outperform, active management is critical. It enables us to position our portfolios to capture the opportunities in the EM and ensure that our clients do not have exposure in areas where we believe there is excessive risk. See Performance Table below for how M&P has provided value to our clients over the long-term.

If you wish to learn more about M&P’s International Equity Strategy, or our other strategies, contact us by phone at 403.234.0005 or emailing solutions@mcleanpartners.com.

Performance Table: 

  YTD 1 Year* 3 Year* 5 Year*
M&P International Equity Strategy 14.1% 23.1% 9.2% 14.6%
ACWI-ex US 10.3% 14.1% 7.2% 12.6%
EM ETF 16.5% 17.4% 6.2% 8.6%

Source: CIBC Mellon, Bloomberg
*Annualized performance
**Performance as of July 31, 2017


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