After lagging for years, emerging equities are back in the winner’s corner. Investors are wondering if the stocks are nearing a durable turn for the better. It’s worth thinking about how the next upcycle may unfold.
From a purely life-expectancy standpoint, the lengthy losing streak in developing-world stocks is getting long in the tooth. In the 27 years since the inception of the MSCI Emerging Market Index, there have been three such half-cycles, averaging eight years (Display). It’s not unreasonable to think that we may be getting closer to an extended turn in fortunes for the emerging-market (EM) stock group as a whole.
So, what would make us more bullish on the prospects for a more enduring stretch of EM beta outperformance? A walk down memory lane suggests that the drivers of prior upcycles will still play a part, but will have less firepower:
•Commodity Supercycle. The decade-long rally that began in 2000 was largely fueled by China’s emergence as a manufacturing powerhouse and its voracious appetite for industrial commodities, which drove booms in fellow emerging countries.
But commodity supercycles come around every 20 to 40 years. The last one peaked in 2010. For the next one to take form, a large part of the globe would need to be industrializing faster than expected. That is unlikely to happen until India or one of the Southeast Asian countries start to invest more heavily in their infrastructure. Even so, with the exception of India, these smaller economies can fill only part of the growth void created by a slowing China.
•Manufacturing Boom. EM growth doesn’t have to be commodity led. Back in the 1980s, the big EM constituents were the booming economies of Mexico, Thailand, Malaysia and South Korea. There was a lot of excitement surrounding Mexico joining NAFTA in 1994; Malaysia and Thailand were delivering GDP growth in the double-digits. Entrance into the World Trade Organization in 2001 was a huge tailwind for China and other emerging economies.
Today, the up-and-coming industrial-manufacturing centers are in Mexico, Vietnam, India, Poland, Hungary and the Czech Republic. We expect them to continue to gain from China’s waning status as a source for low-cost labor and from reviving rich-world demand.
However, these countries lack the workforces and/or physical infrastructure to supplant China, meaning that this trend is unlikely to power an extended, broad-based EM upcycle in the near term. If anything, events suggest a move toward greater regionalization: sanctions against Russia; the Trans-Pacific Partnership, which excludes China; and waning interest among Central European countries to join the eurozone. The benefits from accessing new markets are likely to be much more selective than in the past.
•Reform Efforts. In the aftermath of the currency crises of the late 1990s, we saw widespread adoption of pro-growth reforms aimed at promoting greater exchange-rate flexibility, fiscal and monetary discipline, and capital-market expansion. These reforms have significantly (and, to some extent, permanently) reduced the overall EM risk profile. However, while such efforts are ongoing in some countries, they have stagnated or even regressed in others.
•EM Innovation. The developing world is no stranger to technological innovation. Such advances are creating new, globally competitive leaders across a wide variety of industries. Candidates would include Samsung Electronics (South Korea); Taiwan Semiconductor Manufacturing (Taiwan); Tata Consultancy Services, Sun Pharmaceutical Industries and UPL (India); and Huawei Technologies and ZTE (China). The list would also include fast-growing players in ecommerce, healthcare and personal care, all areas with increasingly credible technologies and brands. Though this trend was not a major market mover in the past, we see investors increasingly gravitating to EM innovators in the years ahead.
There are signs that the sell-off in emerging equities has gone too far. Even after the recent uptick, the MSCI EM index trades at one of the steepest discounts to its developed-market counterpart in a decade.
But many obstacles lie in the near-term path to a more enduring, broad-based EM upcycle. Last time the EM discount was this deep, developing-world ROEs were significantly higher than those of their developed-world peers. On that basis, emerging stocks don’t look so provocatively cheap. The continuing decline in EM earnings forecasts is another hurdle (Display). For a sustained beta turn, we’d likely need to see a return to earnings growth.
All told, while we believe that the four overarching themes of the past highlighted above will remain relevant to investment success in the years ahead, the mix of winners arising from those themes is likely to be very different—and far more idiosyncratic. Finding tomorrow’s EM outperformers will take rigorous research, entailing local knowledge and global industry insights, and a discriminating eye.
MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.