By Brian Wolahan
Since May 2008, the MSCI Emerging Markets equity index has returned -3.5% annualised in US dollar terms compared to +2.9% from the developed World index. The longer term history is rosier, however.
Beginning in January 1988, the inception of the MSCI Emerging Markets index, emerging equities have returned an annualised average of 10.2% versus 7.3% for MSCI World – this despite some sustained periods of underperformance.
Despite their long-term outperformance, emerging equities have typically traded at a discount to developed markets. Relative to the MSCI World index over the past decade, the average discount was 18% on price/earnings, 12% on price/cash earnings, and 7% on price/book. Partly due to the underperformance of recent years, these discounts currently stand at 25%, 22%, and 30%, respectively. However, emerging markets enjoyed a premium to developed markets in the lead-up to the GFC in late 2007 – early 2008, as well as in its immediate aftermath from 2009 – 2011. So what might current valuation discount reasonably imply about future EM returns?
One approach to forecasting long-term equity returns relies on three inputs: dividend yield, expected earnings growth, and changes in valuation. Holding dividend yields at current levels, and assuming 1) nominal 4% earnings growth for both developed and emerging markets, and 2) that valuations will converge to their 10-year averages, one could project a 5.1% annual return for developed equities and 7.0% for emerging markets over the next five years – led largely by valuation reversion.
We conclude that EM equities are inexpensive, and that a modest valuation reversion, not heroic earnings growth assumptions, could generate materially higher medium-term returns than developed markets.
For 2016 and 2017, the IMF forecasts that emerging economies will grow 4.3% and 4.7%, respectively—lower than the 7% annual growth of the mid-2000s but materially above the estimate for advanced economies of 2.1% over both the next two years.
Although past growth has limited impact on forward equity prices, there is evidence that future real GDP growth does positively influence equity returns. Recall, too, that the promising relative EM returns forecast from the simple valuation model was premised on 4% growth in both DM and EM economies.
Energy and materials companies comprise 14% of the MSCI EM index versus 11% of the World index so emerging markets are modestly more exposed to commodities, although some major emerging economies are commodity importers and generally benefit from declines in input prices.
Thus commodity price changes have a heterogeneous impact across emerging markets and we believe that more stability should benefit emerging equities overall.
Following the Fed’s rate hike last December, other major central banks have implemented or extended negative interest rates on deposits. US Treasury yields have also fallen. Tempered rate hike expectations may not be reassuring for equities, in that they reflect concern about global growth. But US domiciled EM investors might benefit from a slowing or reversal of the dollar’s appreciation.
Growth in China has slowed from 14% in 2007 to an estimated 6.7% in 2016—a greater decline than in most emerging or developed economies. This is due partly to slowing growth in China’s export markets, such as Europe and the US However, China’s growth expectations are still considerably higher than those of any other major global economy.
We believe emerging market equities are inexpensive on key valuation measures, providing a sound investment basis for the medium term. Emerging markets also offer greater economic growth prospects and should benefit from the stabilisation of commodity prices and the US dollar. The macro-economic outlook can certainly change, but we believe that a reasonable range of expectations supports the view that EM equities offer greater promise than developed markets over the next several years.
Brian Wolahan is senior vice president and senior portfolio manager at Acadian Asset Management.
