Perfect concoction brewing up for strong emerging market performance
4 min read.Updated: 15 Jan 2021, 07:29 AM ISTViram Shah
The year 2020 was largely lacklustre until the last quarter which saw a strong recovery among EMs—the MSCI Emerging Market index, an index that includes large- and mid-cap companies across 26 EMs, has rallied by 17% since 31 October
The last decade has been a forgettable one for investors in emerging markets (EMs). US stocks outperformed EMs by a significant margin. In the 10 years through 31 December, the S&P 500 returned 11.3% annualized, including dividends, compared with 2.36%, in dollar terms, for the MSCI World ex-USA Index of developed nations and 1.16%, in dollar terms, for the MSCI Emerging Markets Index. The year 2020, too, was largely lacklustre until the last quarter which saw a strong recovery among EMs—the MSCI Emerging Market index, an index that includes large- and mid-cap companies across 26 EMs, has rallied by 17% since 31 October. In fact, the fourth quarter of 2020 is set to register the strongest flows to EM assets, ever since the first quarter of 2013.
The 2020s, though, could be the decade when EMs as an asset class outperforms US stocks. We have the perfect concoction brewing for strong EM performance. So, what’s the recipe for this concoction? Well, it’s four things—a weaker dollar, investors starving for yield, rising commodity prices and attractive valuations. Let’s look at each of these in a little more detail.
Firstly, as the US central bank, the Federal Reserve (Fed), continues to pump dollars into the economy, the dollar has been weakening for the majority of 2020. The Dollar Index, which measures the value of the dollar against a basket of six world currencies, namely euro, franc, yen, Canadian dollar, pound and krona, has slipped by about 7.3% in 2020. Based on their indications, the Fed is in no mood to stop this dollar pumping and this means that the dollar will likely continue weakening. A weaker dollar allows EM governments more freedom to provide fiscal stimulus (increasing government consumption, direct transfers or lowering taxes) without fearing negative implications for their own economies.
Secondly, another key pillar of the Fed’s strategy to support the US economy is near-zero interest rates. The Fed has indicated that it will not hike interest rates for a while. What this means is that institutional investors who have to continue providing returns to their clients need to look elsewhere for returns. Since EMs provide higher yield opportunities, they become the preferred investing destination for these investors.
Thirdly, overall, EMs have always experienced good performance during times when commodity prices are rising. This is because several EM economies derive significant revenues from exporting commodities. Countries like Brazil, Russia, South Africa and Mexico are highly dependent on commodities and perform well when commodity prices are rising. Commodity prices took a hammering in 2020 but will be on the uptrend as economies recover post the covid-19 pandemic. Interestingly, since China and India are net commodity importers, increasing commodity prices do not have a significant positive impact on them.
Lastly, valuations in EMs are currently attractive. One key metric we can look at to ascertain the valuations is the cyclically-adjusted price-earnings (CAPE) ratio. This ratio considers the long-term impact of economic influences by comparing a stock price to average earnings, adjusted for inflation, over a 10-year period. The S&P 500 CAPE in December 2020 was around 33, the second highest it’s ever been and more than 30% above it’s average. Compared to this, CAPE for overall EMs was slightly below the historical average. CAPEs for India and Taiwan were actually higher than their historical averages but other than these two countries, CAPEs for 18 other EMs, including the likes of Russia, Philippines and Indonesia, were lower than their historical averages. A caveat on the predictive power of CAPE ratios is that it relies on the markets remaining structurally similar over time and on valuations regressing to the mean. However, market structures could change over time.
So how does an Indian investor benefit from a potential EM wave over the next decade? Well investing locally in India alone is not sufficient. You need to invest in a diverse set of EMs as a basket or bet on certain countries. If you’re country-picking, then an interesting market to look at is Russia. The Russian corporate sector is well-capitalized and the country has a strong fiscal profile with low government debt. China, too, is promising but the high expectations are likely baked into the prices.
As a retail investor, one of the easiest ways to access international markets is to invest through exchange-traded funds (ETFs) traded in the US stock market. For example, BlackRock’s iShares has an ETF that invests in Chinese mid- to large-cap companies (ticker: MCHI). And, if you are not sure which country to diversify into, there are ETFs that invest across emerging markets; for example, BlackRock’s EEM or Vanguard’s VWO. The Reserve Bank of India’s Liberalized Remittance Scheme allows an Indian resident to remit up to $250,000 annually for international investments.
Viram Shah is co-founder and CEO, Vested, a US SEC-registered investment adviser.