Commentary | Dec 03, 2020

People Get Ready, There's a Train Comin'.


Emerging market (EM) economies have undergone dramatic structural changes since the global financial crisis of 2008-9. We believe that these changes, in combination with superior growth prospects and attractive valuations, will result in significant outperformance of EM vs. developed market stocks over the next 5 -10 years.

Ray Dalio is the founder of Bridgewater Associates, the largest hedge fund in the world. Over the last 20 years, Bridgewater’s Pure Alpha Fund has delivered a near 20% annual compound return before fees. As of March 2020, Bridgewater had approximately 60% of its portfolios invested in emerging markets.

Dalio believes that China is “a comparable power of the United States”. He states, “Would you have not wanted to invest with the Dutch in the Dutch empire? Would you have not wanted to invest in the Industrial Revolution and the British Empire? Would you have not wanted to invest in the United States and the United States empire? I think it's comparable. In a nutshell, it's going to have the largest economy in the world, the most trade in the world, the most market capitalization in the world,” he said. “If you wait for everything to be crystal clear, everything is going to be terrific, but you'll pay a higher price than if you don't.”

Investors need to wake up to the opportunities offered by EM equities and seriously consider allocating a meaningful portion of their portfolios to this asset class.

In case you hadn’t noticed…

Many of the historical risks associated with emerging markets have diminished considerably. As recently as 2012, over 30% of the MSCI Emerging Markets Index was comprised of countries which are reliant on foreign savings such as South Africa, Chile, Colombia, Argentina, Egypt, and Pakistan. These countries are highly exposed to sudden external outflows of capital during periods of financial market turmoil. Such outflows have historically caused EM stocks to suffer significantly deeper losses than their developed market peers in bear markets.

Fast forward to today. The weight of vulnerable countries in the MSCI EM Index has decreased from 30% to less than 18%. Today’s EM universe is dominated by Asian economies that are prosperous and well-run such as China, South Korea, and Taiwan. These countries are superior to many of their developed world counterparts in terms of their fiscal situations, current accounts, and foreign exchange reserves.

China, which currently represents the largest weight in the MSCI EM Index, has transformed itself from an externally dependent economy to one in which the domestic consumer has started to assume a dominant role in driving growth. China has also shown that it has the fiscal and monetary means to rebound from economic shocks and has plenty of dry powder to stimulate its economy should the need arise. In response to Covid-19, China has spent 5% of its GDP on fiscal stimulus, as compared to 13% in the U.S.

From tunnels to technology.

The sectoral composition of the EM universe has undergone major changes over the past decade. Since 2010, the weight of cyclical sectors (energy and materials) in the MSCI EM Index has declined from 31% to 13%. Conversely, the weight of internet and technology companies has exploded from 13% to 33% (think Tencent, Taiwan Semiconductor, Samsung, China Mobile, Huawei, Baidu). This massive shift away from more economically sensitive, pro-cyclical areas in favour of less volatile sectors renders EM stocks less vulnerable to cyclical downturns than has historically been the case.

Go where the growth is – especially when it’s cheap.

Economic growth in emerging markets has far exceeded that of advanced economies. According to the IMF, average annual real GDP growth in emerging countries over the 10-year period from 2010-2019 has been an eye-popping 5.1%, more than double the 2.5% in advanced economies. Importantly, the IMF estimates that this stark disparity in growth will continue for the foreseeable future.

Over the past 10 years, EM stocks have underperformed developed markets by over 7% on an annualized basis, leaving them cheap. The S&P 500 Index’s cyclically-adjusted price earnings (CAPE) is now over 30, a level that was only surpassed at the peak of the tech bubble in early 2000. Conversely, EM stocks have a CAPE ratio that is slightly lower than its historical average. EM equities are inexpensive, both in relative and historical terms. Moreover, considering the improvements in the macroeconomic fundamentals of many EM countries and favourable changes in the sectoral composition of EM stocks, we believe that the current valuation discount of EM vs. DM stocks is unjustified.

So what are we doing about it?

Given the mis-valuation of EM vs. DM stocks and the superior growth prospects of EM vs. DM economies, we believe that EM equities will substantially outperform their developed market peers over the next 5-10 years. Investors should have a substantial allocation to this asset class, which has the potential to be a significant driver of overall portfolio returns.

Given this hypothesis, we wanted to develop an investment strategy to enable our clients to get best-in class exposure to EM stocks. We have spent the last few months at the drawing board (or in our case the data room), with the objective of using our machine learning algorithms to develop a country-rotation strategy that can take advantage of EM opportunities and outperform over the long-term. We have finalized an AI-based investment process that we believe can achieve this objective and are looking forward to discussing this exciting new investment strategy with you in the near future.

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