Do Emerging Markets Equities Deserve a Place in Public Equity Portfolios?

Yes. Emerging markets (EM) equities provide a fitting reminder that relative performance among asset classes varies over time, suggesting that investors maintain well-diversified portfolios to weather shifts in performance cycles. Neither the widespread underperformance of EM equities since the Global Financial Crisis (GFC)—nor a sustained period of EM outperformance—are without precedent. We are neutral on EM equities over a tactical horizon today and suggest investors hold these allocations in line with global equity benchmark weights.

EM versus developed markets (DM) performance cycles are highly cyclical by nature. Over the past nearly 15 years in the post-GFC era, EM equities lagged DM by a staggering 8 percentage points (ppts) per year. A strengthening US dollar, relatively weak EM earnings, and US equity dominance were the primary detractors over this period. However, EM did manage to outperform the DM ex US bloc between 2017 and 2021, highlighting the recent outsized influence of US stocks. EM underperformed broader DM by a similar magnitude in the mid to late 1990s but has also shown the ability to outperform. During the cycle that started in 1999, EM outgained broad DM by a whopping 13 ppts annualized over a nearly 12-year period. Risk-adjusted performance has also been superior to that of DM during relative performance upcycles, despite the higher volatility of EM equities.

Performance cycles tend to be catalyzed by shifts in the macroeconomic backdrop. Just as many investors were wrongfooted by the return of inflation and high interest rates in early 2022, shifting macro conditions can trigger sharp equity market rotations seemingly without warning. A scenario where macroeconomic conditions once again favor EM stocks is not farfetched today. The US dollar’s valuation currently sits at top-decile levels, while economists anticipate a widening in the EM/DM economic growth differential. Coupled with expectations for Federal Reserve rate cuts as early as next month, the potential for a sustained period of US dollar weakening has increased, which would prove a tailwind for EM equities. Finally, the US economy is likely in a late expansion or slowdown phase of the business cycle, where EM’s best performance vis-à-vis DM typically occurs during the following early/recovery stage of the cycle.

Won’t DM equity allocations provide ample exposure to the EM bloc, given the globally diversified revenue base of many DM stocks? This is one argument that has been offered to avoid allocating to EM. However, it does not hold water. According to FactSet, only 23% of DM company revenues are generated in emerging and frontier markets, where China alone accounts for nearly one-third of that total. In contrast, more than 70% of EM company revenues are derived from emerging and frontier markets, suggesting that EM allocations are the best way to achieve true exposure to EM. Further, EM equities themselves are fertile ground for active managers to add value.

Right now, EM equities also help reduce exposure to richly priced US equities. Global equity benchmarks are more exposed than ever to US stocks, which account for a record 65% of global equity market cap. And said exposure does not come cheap. The US market currently trades at more than 21x 12-month forward earnings. By contrast, EM equities trade at a forward price-earnings ratio of just 12x, reflecting a near-record valuation discount. While such a valuation disparity itself does not warrant an overweight stance to EM, investors should continue holding EM stocks as valuations tend to be more meaningful over longer-term periods. Further, we question whether US equity exceptionalism can be sustained, given today’s high earnings per share growth expectations, lofty valuations, and profit margin sustainability concerns.

EM equities may benefit from nascent structural trends over the longer term. These include US/China decoupling, nearshoring, technological innovation and adoption (including digitalization, fintech, and artificial intelligence), and growth of the middle-class consumer. These factors have already been reflected in recent equity returns and a shifting EM index composition. India (14.6%), Mexico (7.3%), and Taiwan (7.2%) have all outperformed DM equities (6.8%) over the prior three years, while China’s weight is down nearly 20 ppts, from a peak of 43% in 2020 to just 25% today. ASEAN countries have already started to benefit economically from shifting supply chains, and we expect that potential for increased foreign capital flows will create tailwinds for these equity markets over time.

Investors tempted to abandon EM equities altogether would be wise not to extrapolate the recent past into the future, as they may yet benefit from EM equity allocations at subsequent turns in the cycle. In the meantime, EM equities offer a wide opportunity set for skilled active managers to add value. We remain neutral on EM equity allocations today and recommend investors hold these allocations in line with their weight in global equity indexes, having recently closed an overweight recommendation to Chinese stocks.

Stuart Brown, Investment Director, Capital Markets Research