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By Nathan Chaudoin - February 7, 2018
Emerging market (EM) equities have appreciated significantly since 2016, handily outperforming developed markets. This rally has left many investors concerned they missed their chance to invest. Here’s why we believe there may still be opportunities in the EM space, and why investors should consider making emerging market equities a strategic part of a diversified portfolio.
EM Stocks Have Outpaced Developed Market Stocks Since Early 2016
Data from 1/21/2016 to 12/31/2017
Source: American Century Investments, FactSet
Definitions: MSCI Emerging Markets Index, MSCI World Index, S&P 500 Index
Despite the impressive EM run-up, we believe there is still room for growth. The current rally follows a difficult period for EM coming out of the global financial crisis. Before 2016, several conditions weighed on EM economies: growing EM debt, sluggish economic recovery in developed markets, and slowing demand from China. As these conditions improved, we saw an upswing, which may continue as conditions improve further.
The extent of the downturn also suggests that EM may have additional upside potential – as does historical context. Over the last four decades, EM stocks have experienced six bull markets. These lasted on average 3.5 years, with stocks gaining 230%1. In contrast, the current EM rally is less than two years old, with stocks only up 68%. While past performance is no guarantee of future results, if the current rally were to approach historical averages, it may conceivably continue for some time.
Looking Back at Historical EM Bull Markets
Historical length and cumulative returns of EM bull markets.
Data from 10/31/1976 to 10/25/2017
Source: BoA Merrill Lynch Global Research, FactSet, GFD
Synchronized global growth is helping sustain the EM rally. As economic conditions have strengthened in developed markets, boosting business and consumer confidence, demand for EM goods and services has also increased. Federal Reserve (Fed) policy slowing U.S. interest rate normalization may also ease pressure on EM economies.
Improvements closer to home are also driving emerging markets’ expansion. EM companies exhibit superior earnings per share (EPS) growth relative to developed markets, supported by improving global economics and increasing local demand. Relatively low local inflation and interest rates are easing access to credit, which helps fuel local businesses and drive domestic demand. A growing middle class is leading to increased demand for quality-of-life and status goods and services, which is also helping to increase local earnings growth for companies in many industries.
EM Earnings Growth is Improving
Results are in USD. Calculated using recurrent earnings. Forecasts are not a reliable indicator of future performance.
Data from 12/31/2005 to 9/30/2017.
While we believe the EM rally may still has room to expand, we realize markets are fluid. It’s possible for conditions to shift and present stumbling blocks. So, what risks could slow or end the rally?
With the change in the U.S. Federal Reserve leadership, there is some uncertainty regarding future monetary policy. An abrupt change in Fed policy could unsettle global markets and cause volatility in the intermediate term, which could be detrimental to global stocks generally, and EM equities in particular. An increase in U.S. rates too quickly could hinder U.S. expansion, and in turn global recovery. This could lead to inflation, which may jeopardize market performance.
While local EM conditions have improved, much of the growth has resulted from external demand from recovering developed markets. For the rally to remain sustainable, we would need to see ongoing improvement in domestic demand. EM growth is also heavily dependent on stabilization in China, and an abrupt slowdown could hinder a continued rally.
Emerging markets equities have shown strength and resilience since early 2016. The current run-up has been impressive, and we still see reasons to be optimistic; both the historical case for emerging markets and current macroeconomic conditions support this view. As always, there are risks that could slow or stifle the recovery, but we believe this is unlikely. So, we remain positive on the long-term secular growth story in emerging markets and believe the current upswing is in its early stages.
While the long-term case for EM is well documented, EM equities still only represent 2.5% of the average investor portfolio2.With earnings per share growth rates in 2017 estimated to be about 50% higher in EM compared to developed markets (24.4% vs. 16.3%), lack of exposure to emerging markets equities could be a miss. Emerging markets make up most of the world’s population (more than 85%), and more than half of global gross domestic product (GDP). EM countries are projected to comprise 80% of the world’s middle-class consumers by 2025.
Due to the diversification benefits and potential for a continued rally within emerging market equities, we think investors should consider making EM a dedicated allocation within an overall portfolio, as appropriate.
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The recent negative equity market response—despite limited economic exposures—reflects how markets are trying to price in the risk of escalated US protectionism, rather than any specific tariff. We believe the steel and aluminum tariffs will have a limited impact on emerging markets.
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Nine months ago, investors anticipated challenges for emerging markets. Turns out, there were reasons to be optimistic.
August 17, 2017
1“Two for Two: Asia/EM Equities like to double in two years,” Bank of America Merrill Lynch Global Research, September 14, 2017.
2Source: Morningstar Direct. Data as of September 30, 2017.
International investing involves special risks, such as political instability and currency fluctuations. Investing in emerging markets may accentuate these risks.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of American Century Investments (or the portfolio manager) and are no guarantee of the future performance of any American Century Investments' portfolio. This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.