The term emerging markets (EM) refers to developing countries that are becoming more industrialised with greater trade activity, and as a consequence are engaging with global markets. The breakdown of GDP growth between trade and consumption are key dynamics to watch over the medium and long term. Emerging market economies include the likes of India, China, Brazil, South Africa, Russia and Vietnam.
Historically, companies with higher than average growth trends trade at a higher share multiple valuation than those companies with lower growth trends. Logically, there is a high correlation between a region’s GDP growth and domestic company earnings growth. Considering this, a rational investor could justify paying a valuation multiple premium for emerging market exposure given its higher growth profile. Currently emerging market valuations, 14x 2020 earnings, trade at a steep discount to many developed markets and are therefore compelling on a number of fronts. Hopefully the Coronavirus has both a limited and only short-term impact, as has been the case with other previous virus outbreaks (SARS, Ebola). If so, strategically adding to EM in the short term, for long term gains has merit.
A review of the MSCI Emerging Market Index (heavily weighted towards Asian economies) highlights an index that is still 18% below its peak level recorded in 2007 and has been consolidating sideways for over a decade. In contrast the S&P 500 Index is now trading 135% above its peak recorded in 2008, and European equities (SXXE) are within touching distance of 2008 index levels. Emerging market valuations (7% earnings yield) are much more compelling than the US (<5% earnings yield).
Reviewing 2020 outlook expectations, investment bank consensus expects global growth of 3.2%, up from 3% in 2019. China (+6% YoY), India (+6.3% YoY) and Brazil (+2.2% YoY) are expected to be the key drivers of global growth in 2020 as US, Europe, UK and Japan growth rates are expected to stall or slow. Emerging market growth is more structural in nature whilst conversely, developed market growth is more cyclical. Technology is of course positively impacting growth globally. Putting technology to one side, assuming all regions will benefit equally from such technological gains, there is much more downside risk to cyclical growth as we move toward 2021/2022. In fact, consensus forecasts imply that G10 growth momentum may, in fact, have peaked already.
2019 was a year of interest rate cuts (49 central banks reduced rates 71 times) and further loosening of monetary policy, including balance sheet expansion at the Fed, the ECB and the Bank of Japan. Expectations are now that the US$ may have peaked with the Fed thought to be on hold through 2020. A weaker dollar and lower energy prices benefit emerging market economies and businesses.
Investors have shunned EM as the trade war between the US and China unfolded. Tariffs negatively impacted sales in China and interrupted the supply chain of international companies. For instance, Caterpillar (designer and manufacturer of construction, mining and forestry machinery) reported a 14% decline in Asia Pacific revenue in Q3 2019. Now that a phase one deal has been done, expectations are that EM should benefit as much, if not more, than the US. Expectations are that Caterpillar could deliver double digit Asia Pacific sales growth through Q3 2020 post the signing of the phase one trade deal. Judging by a recent fund manager survey by Bank of America, other investors agree that emerging markets are now compelling and have been adding to the region in January 2020.
In the medium term, urbanisation will continue to drive growth in emerging markets. As the process of urbanisation unfolds, GDP per capita will rise and consumption will grow. The trend of being educated in, or sourcing better paid work in urban locations has been and remains a common theme globally but the opportunity is greater in emerging markets. As people move to urban areas they tend to earn more and spend more on luxury items such as dining out. A denser population also affords greater investment in urban infrastructure. Urbanisation drives consumption, which has been and will continue to propel sustainable growth. For instance, the urbanisation rate in China is c.55% versus over 90% in Japan and 80% in the USA.
For clients who can handle some additional risk and volatility whilst taking a longer-term view, any temporary correction in emerging market indices over the short term should present a good opportunity to accumulate better long term gains. We have added an allocation to emerging markets within our Core Portfolio via the JPM EM Investment Trust. This instrument is a UK listed asset with a risk weighting of 4. The trust has a 32.8% weighting in China, 20% in India and the balance spread across other emerging markets such as Brazil and Taiwan. Its top holdings include TSMC, HDF, Alibaba, Tencent and AIA. In addition, some of our other discretionary funds hold shares in companies with significant emerging market exposure such as Unilever, Prudential, LVMH and Rio Tinto.
Darren McKinley is Senior Equity Analyst with Cantor Fitzgerald.
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