Many investors have been dismayed by the underperformance of emerging market (EM) equities compared to those of developed markets over recent years (see exhibit 1 below):
Exhibit 1: Returns of emerging market equities have lagged those of developed market equities in recent years (graph shows performance of the MSCI Emerging market index (MXEF) relative and the MSCI World developed market index (MXWO) between 14/01/15 and 04/04/17).
Source: BNP Paribas Asset Management, Bloomberg as of 04/04/17
The recent rebound in the performance of EM equities relative to their developed market peers (see exhibit 2 below) raises the following question: is the recovery structurally sound or just temporary mean reversion?
Exhibit 2: Emerging market equities have rebounded after the sell-off triggered by the election of D Trump in November 2016 (graph shows performance of the MSCI Emerging market (MXEF) and the MSCI World developed market index (MXWO) between 10/10/16 and 04/04/17)
In this article, we examine what we view as misconceptions behind some of the bearish views on this asset class. In a second article we will review the structural reasons as to why we believe that the future for emerging market equities is bright.
Misconceptions about EM equities
It seems to us there are two, inter-related, pessimistic views on EM equities, namely:
(i) that EM equities are simply a commodity play and that the commodity super-cycle peak will not be revisited anytime soon
(ii) that EM economic growth has mainly depended on a China whose future economic expansion will be appreciably slower.
The notion that emerging markets are disproportionately exposed to commodities is, in our view, inaccurate. Compared to the all-capitalisation MSCI World IMI (Investible Market Index), the MSCI Emerging Markets IMI is no more exposed to the energy and materials sectors.
Nor is it true that EM economies are disproportionately exposed to commodities. Demand for consumer goods would be dependent on energy and materials prices if a large share of EM economies was comprised of commodity-related sectors. But this is not the case. While in emerging market economies the mining sector is twice as important as it is for developed markets, in absolute terms it is still quite small (comprising just 3.5% of gross value added (GVA) in EMs compared to 1.7% for developed markets). Manufacturing does make up a relatively larger share of EM economies’ gross value-added (GVA), but for both developed and emerging markets, the services sector is much more significant (see Exhibit 3).
Exhibit 3: Analysis of gross value added (GVA) by the principal economic sectors in emerging and developed markets does not suggest that EM economies are overly dependent on commodities
Data latest available as at 31 January 2017. Source: Haver Analytics, BNP Paribas Asset Management.
China can do it! (Make the transition from an export-led economy to one built on domestic consumption)
The China boom of the past decade was led mostly by fixed-asset investment. It gave rise to China’s insatiable appetite for raw materials. As an illustration of this, between 2009 and 2011, China used more concrete in its roads, railroads, dams, bridges, factories and buildings than the US did in the infrastructure it built during the entire 20th century. As China imported copper from Chile, soybeans from Brazil, iron-ore from Australia, coal from Indonesia… not only did it provide foreign exchange-based earnings around the developing world, but it also encouraged the roll-out of large infrastructure spending plans with terrific externalities.
However, China’s fixed asset investment growth has now peaked and commodity prices have plummeted. We’ve gone from a global China boom to fears of a China bust. This bearish argument seems logical because it is based on the idea that Chinese economic growth is a simple creature of government-directed infrastructure investment supported by lower GDP growth and an ageing population.
In our view this analysis fails to recognise the economic transition taking place in China as it shifts its focus from capital deployment to achieving returns on its invested capital. The old macroeconomic policies of artificially low interest rates, an artificially low exchange rate and strict capital controls are now gradually being replaced with more market-driven real interest rates that force greater efficiency and that should shift capital from state-owned companies to more efficient private ones.
China is beginning to open its economy, and the renminbi is following a more market-driven exchange rate. As the renminbi becomes more actively used for international trade and investment, it should reduce the impact on emerging markets of US dollar fluctuations.
As China exports cheaper value-added products to its Asian neighbours, these countries should themselves become more productive, creating further investment opportunities. The dispersion of returns across industries likely to benefit from the greater productivity associated with access to more advanced technology should widen, allowing active investors more opportunities to generate alpha from a bottom-up perspective.
Published 10 April 2017
This article is a précis of a paper written by Daniel Morris and Quang Nguyen. The full version of this paper can be accessed here.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.