In the geographical allocation of investment, most investors tend to be underweight in emerging countries. The reasons for this underweight can be attributed to risk aversion or skewed strategic asset allocation. It can also be due to ignorance.
Over the long term, a persistent underweight to investing in emerging markets is shown to be detrimental to higher returns as there are periods when their stocks significantly outperform developed markets. It’s true that for the last 10 years, being underweight has worked as only the S & P500 has outperformed stocks in other developed and emerging international markets by almost 2.5 times.
But this has changed. At least that seems after the start of the year already following last year’s pattern, the all-time highs in emerging indices suggest an unexpected party guest if we backtrack even before the pandemic develops.
Why are emerging markets important? As the share of world GDP shifts more and more to emerging countries, the weight of stocks becomes increasingly important. Emerging economies have more than 60% of world foreign exchange reserves, generate around 60% of global GDP and concentrate more than half of the population.
Considering that approximately a third of companies are listed in emerging markets and that they only represent 12% of global capitalization, the allocation of pesos is surprising.
“Emerging economies have more than 60% of world foreign exchange reserves, generate around 60% of global GDP and concentrate more than half of the population.”
Emerging markets have changed considerably in the last decade and are no longer the homogeneous group that historically tended to move en bloc. Much of the blame is obviously China and India.
The differentiated characteristics of each country within the index and their diverse responses to global economic drivers lead to increasingly less correlated returns. This creates opportunities for the active allocation of weights and reduces the volatility of portfolios with greater exposure to emerging markets.
The doubts about how emerging countries were expected to withstand the pandemic were more than important. But the data suggests that they have been less affected relative to developed countries. Despite the limited capacity to implement fiscal or monetary stimulus, emerging economies are expected to generate higher GDP growth in 2021 after a decline in 2020 that was already lower than that experienced in developed ones.
However, the expected increase in GDP growth will not be uniform in all emerging countries. And the blame for this lies in the weight of China, the second largest economy behind the US China accounts for almost 15% of the world’s real GDP with no signs of that trend reversing. It is debatable whether China should be included in the “emerging” category, but the point is that it is the largest weight in the MSCI Emerging Markets index.
The demographic factor is critical. Middle class growth is projected to make up more than 60% of most major emerging markets from the current level below 50%.
Furthermore, there are studies that suggest that the growth of the middle class in the two most populous countries in the world, China and India, will double and quadruple respectively by 2030, which contrasts with a population growth in the United States that is half than it has historically grown up with a stagnant middle class.
“There are studies that suggest that the growth of the middle class in the two most populous countries in the world, China and India, will double and quadruple respectively by 2030.”
Historically, emerging market equities have provided investors with substantial returns but have also generated crashes during periods of greatest turmoil.
Contrary to this circumstance, it is worth dwelling on the fact that only relative valuations are at extreme levels but that the growth rate of earnings is expected to be higher for emerging markets.
Analyzing emerging vs. developed comparatively, the average historical discount on book value is approximately 20%, which reflects the interest of investors in paying a higher price for the benefits of companies in developed markets.
However, the current relative discount is at levels above 35%. A simple mean reversion could result in a significant outperformance for emerging markets.
If we look at it in PER terms, despite a similar relative discount, it is also true that emerging market stocks are not cheap in absolute terms. This is offset by the fact that the expected EPS growth for emerging markets is 50% higher than expected in developed ones.
Such an underweight may lead to positive flows as funds move out of asset classes that have outperformed over the past 10 years and into higher-positioned asset classes, either due to valuation or outlook for growth. growth.
There are many who believe that emerging markets are better positioned for a solid rebound. The recovery in the price of raw materials and the weakness of the dollar are a tailwind for many of these economies.
” Investing in emerging market equities is not without risk ”
Investing in emerging market equities is not without its risks: the pandemic, protectionism, and the escalating trade war, not to mention political, regulatory and unforeseen risks that seem to belong only to emerging countries.
Emerging companies often perform worse in the course of a crisis, and the recent sharp pullback was no exception. But it is also true that historically their actions have recovered quickly, as has happened since the pandemic. After the GCF, emerging market equities outperformed developed markets in the next two years.
The risks of overvaluation of the North American market and the need to seek yield therefore make it necessary to review the allocation of the weight of emerging markets in the portfolio.