- Many emerging markets (EMs) are in the early stages of economic recovery. This should support a higher‑than‑average growth premium relative to developed markets.
- EM equities have evolved. The influence of energy and other commodities has declined; inflation is relatively controlled; capital spending is more disciplined.
- Today there is greater variation between EM stocks that are tied to their local economies versus those that are linked to global growth.
- We believe an allocation to EM value potentially can improve diversification, raise risk‑adjusted returns, and provide effective exposure to the growth premium.
Given the volatility in emerging markets in 2018 and the impact it had on long‑term relative performance, it is somewhat understandable that institutional investor exposure to the asset class is near multiyear lows. However, emerging markets have evolved and changed over the past few years in ways that may surprise investors, particularly when they consider the benefits increased EM exposure potentially could have in their overall portfolios.
In our view, EM equity today is a broader and more dynamic opportunity set than most investors appreciate. In a recent discussion with Ernest Yeung, portfolio manager of the Emerging Markets Discovery Equity Strategy, and Lowell Yura, head of Multi‑Asset Solutions, North America, we posed the question: Is now the right time to rethink EM allocations?
Q: What is your view regarding the prospects for EM equity?
Ernest Yeung: Ten years ago, people thought that EMs were tied to commodities and were very volatile. But over the last eight to 10 years, the correlation of the asset class to commodities has collapsed because the country composition of the opportunity set has drastically changed and keeps changing.
Consider that 20 years ago, Malaysia actually was the largest country in the Morgan Stanley Capital International (MSCI) Emerging Markets Index. Today, China has experienced a huge increase in weighting, as most investors see a lot of opportunity there. Conversely, there is relatively little investor interest in Malaysia—although we are uncovering interesting opportunities there today. This is a simple example of how dynamic this EM opportunity set is and how the composition has changed over the years.
(Fig. 1) The EM Opportunity Set Has Shifted Dramatically
Select Country Allocations Within the MSCI Emerging Markets Index
December 31, 1988, Through March 31, 2019
Sources: Credit Suisse (see Additional Disclosures), FactSet (see Additional Disclosures), MSCI (see Additional Disclosures).
We believe that we are actually in the early to middle stages of an EM cycle. Most investors realize that emerging markets are a good place to invest, but in the past, they have collapsed roughly every 10 years. If you invested in years number eight and number nine, you potentially had a problem. So having a rough idea where we might be in that 10‑year cycle is very important.
To assess where we could be in this cycle, we consider the GDP differential between EMs and developed markets. EMs hit a trough in economic activity in the first quarter of 2016, so we are just two and a half years into a fundamental upcycle. I have good confidence that EMs will continue to recover and believe that tailwind is unlikely to subside in the near term.
Q: What do you think are some of the biggest misconceptions that investors have about EM equities?
Ernest Yeung: Most investors don’t realize that the ratio of capital expenditure (capex) to sales among EM companies is actually at a 15‑year low. When corporations are not spending as much on capex, it suggests there are no excessive animal spirits in the asset class. Businesses today are acting very rational and very disciplined. These are signs of an early‑ to midcycle mentality. You would worry about reckless growth in the late stage of an economic cycle, but we do not see that currently happening in emerging markets. Companies and governments are tightening their fiscal belts and allocating capital very tightly and efficiently.
This discipline is also evident in more reasonable monetary policies, which have driven EM inflation down to near‑record lows and produced relatively high real interest rates.
Q: What are the implications of low capex for EM economies and equities?
Ernest Yeung: Today, when we visit and speak to corporate executives within EM regions, they tell us that they have underspent on capex in the last few years. In fact, in many cases capital expenditures have been below depreciation and amortization. In other words, companies are spending below what would be considered normal maintenance levels.
Executives tell us that they plan to increase investment spending in the near future. This is actually a very powerful signal that could help support a virtuous cycle in the asset class: The money they spend on capex is likely to bring a higher return. It also should create more jobs, which would be good for wages and consumer income and so good for EM economies.
Finally, companies will need to borrow to invest in capex, and we believe that will kick off a positive credit cycle. So, my conclusion is that we are still early in this economic cycle. As such, we continue to be very constructive looking forward.
(Fig. 2) EM Corporations Are Taking a Disciplined Approach to Capital Spending
Ratio of Capital Expenditure to Sales for Companies in EM Indices
December 31, 2008, Through March 31, 2019
Sources: FactSet (see Additional Disclosures), MSCI (see Additional Disclosures).
Q: Lowell, what is the most effective way for investors to tap in to the benefits of these developing economies, in your view?
Lowell Yura: At a macro level, there is still an opportunity to achieve economic and interest rate diversification between emerging and developed markets. That said, EM investors need to go down to country and sector levels and look at the way the major EM equity indexes are constructed to make sure that their EM allocations actually are positioned to achieve higher growth rates and adequate diversification.
The relative weights of the technology and financials sectors in various EM indices shows the importance of analyzing index construction and underlying exposures. For example, technology makes up about 20% of the MSCI Emerging Markets Growth Index, but only 10% of the MSCI Emerging Markets Value Index. Many of the largest technology companies in those indices are levered to the global economy, not to the growth of their underlying EM regions.
(Fig. 3) The Growth Gap Between Developed and Emerging Markets Could Widen
Growth in Real Gross Domestic Product
Actual: December 31, 1980, Through December 31, 2018
Projected: December 31, 2018, Through December 31, 2022
Sources: China National Bureau of Statistics, Federal State Statistics Service, Instituto Brasileiro de Geografia e Estatistica, European Central Bank, Bank of Japan, IMF, Haver Analytics. T. Rowe Price calculations using data from FactSet Research Systems Inc. All rights reserved.
Emerging Markets Value Index. Many of the largest technology companies in those indices are levered to the global economy, not to the growth of their underlying EM regions.
On the other hand, financial companies may be very levered to their local EM economies because they typically lend to businesses in those economies. As local economies improve, lending tends to increase, profitability tends to improve, and financials generally should benefit directly from those trends. Financial stocks make up only 12% of the MSCI Emerging Markets Growth Index, 25% of the broad MSCI Emerging Markets Index, and a bit more than 33% of the MSCI Emerging Markets Value Index. While 33% is a high concentration, it is one way to think about EM diversification and the benefits of a dedicated value allocation.
(Fig. 4) A Tilt Toward Value May Produce a More Efficient EM Portfolio
Composition of an Efficient Frontier EM Portfolio at Different Levels of Tracking Error* 15 Years Ended December 31, 2018
Historical Tracking Error (Percentage)
Maximum Information Ratio: 70% Core, 30% Value, 0% Growth
Sources: T. Rowe Price, eVestment Alliance, LLC. All data analysis by T. Rowe Price.
*Values represent gross returns. Median excess returns were calculated against the MSCI Emerging Markets Index. Hypothetical portfolios were rebalanced monthly. Portfolio blend represents active equity strategies within the eVestment Alliance database, separated into emerging markets subcategories based on manager investment style: core, growth, or value. See appendix for additional information on the methodology.
Q: How should those factors be reflected in strategic asset allocation and portfolio construction?
Lowell Yura: To answer that question, let’s look at active returns and the median returns of all managers in eVestment Alliance’s EM core, value, and growth peer groups. If you were to look back 15 years as of December 31, 2018, what allocation among those three types of managers could have delivered the highest information ratio for the lowest tracking error?
What we found was that the lowest median tracking error over that 15‑year period was for the core EM peer group—as you would expect, because the index tracked was the broad MSCI Emerging Markets Index. If your objective was to increase tracking error and excess return, you initially would have tilted toward value managers at the expense of core. However, if you desired even higher tracking error, ultimately you would have started to tilt toward growth managers.
What’s interesting about our optimization study is that this growth allocation did not come at the expense of value. It increasingly came at the expense of core. In fact, over the last 15 years as of December 31, 2018, the portfolio with potentially the highest information ratio would have allocated 70% to core, 0% to growth, and 30% to value.
Now as asset allocators, we’re born skeptics, and we have very little confidence in historical returns because we know there’s a lot of bias. So we looked at this analysis through multiple lenses (such as using resampling and statistical methods to remove factor and time‑period bias) and found similar patterns of results.
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Equity Risk- In general, equities involve higher risks than bonds or money market instruments.
Currency Risk- Changes in currency exchange rates could reduce investment gains or increase investment losses.
Emerging Markets Risk- Emerging markets are less established than developed markets and therefore may involve higher risks. The portfolio has increased risk due to it’s ability to employ both growth and value approaches in pursuit of long-term capital appreciation.
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