Several of our clients and our partners have encouraged us to increase the frequency at which we post thoughts and ideas to our website. At a recent offsite, we agreed we should make that a priority for 2022. Consider this an early new year’s resolution and thank you for your feedback.
One of the most disappointing trades of the year has most likely been Emerging Markets (EM). After leading the world higher through mid-February, up 12%, the index gave back its gains and is essentially flat for the year. In contrast, the US is up over 25% and the rest of the developed world is up 13%. If we could strip China out of the EM index, the rest of the emerging world is up nearly 10%.
With that as a backdrop, we thought it is important to revisit why we own EM and why we expect EM to continue to be a long-term strategic holding for our clients.
Emerging Market economy statistics:
- EM countries account for 85% of the world’s population and even more of the world’s population growth
- Over 50% of global GDP (Purchasing Power Parity-PPP)
- EM countries are estimated to grow at double the pace of their developed counterparts
- Higher birth rates and younger populations. Birth rates are one of the leading indicators of economic growth and market performance over the long term.1
- Low debt to GDP ratios
- More potential to benefit from technology and productivity
Despite the size of emerging market economies, in many respects, they still only represent 11% of the investable equity market universe. We expect EM’s contribution to global equity markets to increase over time (albeit, not in a linear fashion) as EM populations move into the middle class and adopt technologies that improve productivity.
There are risks, to be sure, and it’s important we highlight those alongside the opportunities:
- Political instability/corruption
- Currency fluctuations
- Regional conflict
- Weaker property rights and less business-friendly laws
We continue to believe the benefits outweigh the risks long-term.
So, why the weakness in EM this year?
As mentioned previously, China has been a major detractor from the rest of the EM equity index. China makes up over 30% of the index and has a weight twice that of the next largest country (Taiwan). The crackdown on tech in China has been running for a year now. In November 2020, the Chinese government managed to scuttle one of the most anticipated IPOs ever for a fintech company – Ant Group. At the same time, Jack Ma, the founder of Alibaba, disappeared for several months after making negative comments related to bank regulation in China. In late June, Didi, the ride hailing app, hurriedly pushed out an IPO in the US, only to have the Chinese government, less than a week later, order the app removed from app stores. In the same month, a crackdown on the robust private education market hammered the shares of education companies. Finally, in September the world’s most indebted property developer, Evergrande, fell into financial distress missing an interest payment. Ever since then, the company has been narrowly averting default by paying missed interest payments within the grace period allowed. Needless to say, it’s been a tough year in Chinese markets.
We are cautiously optimistic that recent developments are indications the worst may be behind us. Recently, the Chinese government came out and offered a bit of a road map for private education companies to stay in business and (in certain areas) make a profit. As previously mentioned, Evergrande continues to make its interest payments although the ultimate outcome is far from certain here.
So, where does that leave us in Emerging Markets?
Although the Emerging Market index (see Chart 1 below – white line) is essentially unchanged on the year, increases in earnings expectations (green line) have cheapened the index from a Price-to-Earnings ratio perspective back to pre-pandemic levels (yellow line).
Relative to the S&P 500, this is the cheapest EM equities have been to the US in well over a decade with the US trading at more than a 60% premium to EM (see Chart 2 below).
Another way to look at the relative performance of US vs EM is simply looking at the ratio of the S&P 500 index to that of the MSCI EM Index. Again, from this measure, we are very near the richest levels of the S&P 500 vs EM in history. The yellow line shows the Dollar Index. Generally, as the dollar strengthens, so does the S&P 500 vs MSCI EM. Starting at the end of 2019, the two started to diverge (see Chart 3 below).
There is some debate among investors as to whether EM should or should not be a strategic holding in portfolios. At Custos, we have extensively reviewed whether there is merit to trying to time EM equities. We’ve found that to be incredibly difficult and we’ve not found a manager we think does it well. EM equities have the tendency to make a half decade worth of gains in 12-18 months, and then trade sideways to down for the balance of the period. Missing the crucial 12-18 months wipes most, if not all of the expected return over a given holding period. We continue to be long-term holders of EM equities and prefer owning Emerging Market equities over Developed Market Ex-US, because almost all of the tailwinds listed above for emerging markets are not present in Europe and Japan.
1There have been several studies of this, here is the link to a couple of them:
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The views expressed in this newsletter represent the opinion of Custos Family Office, a Registered Investment Adviser. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment or services. The information provided herein is obtained from sources believed to be reliable, but no representation or warranty is made as to its accuracy or completeness. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. Investments are not a deposit of or guaranteed by a bank or any bank affiliate. Please notify Custos Family Office if there have been any changes to your financial situation or investment objectives or if you wish to impose or modify any reasonable restrictions on the management of your accounts through Custos Family Office.