Have fears for emerging markets been overstated?

 

Trade wars and a global slowdown have been top of investors’ minds recently. But has the potential impact of these factors on emerging markets’ growth been overstated? Raheel Altaf examines the facts behind the headlines… 

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Over the past 10 years, emerging-market equities have trailed other regions.

10-year total return

Will the next 10 years be different? In terms of relative valuations, emerging-market equities now look much more attractive. In 2009, emerging-market equities were trading at a premium to the S&P 500. This premium has been steadily eroded and they are now trading at close to their lows in relative valuation:

Shiller P/E – EM vs. S&P 500

Despite the attractive valuations, investors seem reluctant to allocate to emerging markets and remain underweight within global equities. What could cause this to change?

Top of investors’ minds…

 

Slowing global growth, Trump’s trade war and political risk have all weighed on sentiment recently. But are these legitimate concerns? While global GDP growth is slowing down, this will have more of an impact on developed markets than emerging markets, which are still forecast to grow by nearly 5% this year. China, which makes up 30% of the MSCI Emerging Market index, is still forecast to grow by over 6%, far ahead of the US and Europe¹. Emerging markets are also better equipped to deal with a slowdown, as most have much more potential for stimulus – both monetary and fiscal – than developed markets.

Any negative development in the trade war between the US and China has tended to cause indiscriminate selling of emerging market equities. It is viewed as a threat to Chinese growth but also to globalisation in general. Yet we think the potential effect on China is overstated. Thanks to growth in the domestic economy, China is much less reliant on exports than it used to be. In 2018, exports accounted for 19.5% of Chinese GDP².

Around 18% of exports went to the US³, so trade with the US is now responsible for only around 3% of Chinese GDP. And where China potentially loses, other emerging markets may gain. Vietnam, for example, has benefited from a shift in production away from China: its exports to the US were up 33% in the first half of 2019.

For investors in emerging markets, political risk is a constant. The most recent example is Argentina where the incumbent president unexpectedly lost a primary election to a populist left-wing candidate, causing the value of the peso to plunge. Yet there is unlikely to be contagion to the rest of the region. While Argentina may dominate headlines, its economic importance is much diminished after a series of crises. As an illustration, Argentinian equities now make up only 0.18% of the emerging markets index.

The bigger picture…

Are short-term headlines distracting us from the longer-term picture? Emerging markets’ growth story is not over.

 

Emerging markets’ share of global GDP is steadily increasing and in 2019 has reached nearly 60% (at purchasing power parity), up from 50% a little over a decade ago⁴. China is expected to overtake the US as the world’s largest economy by 2030.

Much of this growth will be fuelled by the spending power of an increasingly affluent middle class. An additional 1.6 billion people are forecast to enter the middle class between 2015 and 2025.Of these, the vast majority (1.4 billion) are in the Asia Pacific region. To put this into perspective, in Europe only 14 million are expected to join the middle class⁵.

Emerging markets are the leaders of tomorrow in innovation. Applications for patents in emerging markets have grown rapidly over the past 20 years. In 2018 there were 1.7m applications from emerging markets as a whole – over three times as many as in the US⁶. Many of these came from Chinese companies – an indication of the transformation of the Chinese economy. This investment in research and development should underpin future growth.

The current opportunity

Emerging markets are not homogeneous. Rather, they are a highly diverse set of economies and industries. They also trade at a wide range of valuations.

A wide range of valuations

 

Currently, the dispersion in valuations across emerging markets is at extreme levels:

Valuation dispersion is high in emerging markets

Emerging markets valuation spreads

This dispersion in valuations presents opportunities for active managers. The headline average valuation hides plenty of cheap companies with good prospects.

Over the last few years, investors have seemed willing to ‘pay up’ for growth by crowding into expensive defensive companies. Yet by doing this they have ignored the main source of future growth – emerging markets. Investors are currently more underweight the asset class than they have been for the past 10 years⁷, so there is a low hurdle for additional investment. We believe the current opportunity is particularly compelling.

¹ Source: Bloomberg consensus forecast as at 30 August 2019.
² Source: World Bank https://data.worldbank.org/indicator/ne.exp.gnfs.zs
³ Source: https://www.thebalance.com/china-economy-facts-effect-on-us-economy-3306345
⁴ Source: IMF as at September 2019. https://www.imf.org/external/datamapper/PPPSH@WEO/OEMDC/ADVEC/WEOWORLD
⁵ Source: Brooking Institute report, July 2019.
⁶ Source: International Patent Office as at June 2018.
⁷ Source: EPFR Global, RefinitivDataStream, HSBC ‘Monthly GEMs Equity Flows’ report as at 30 July 2019.

To find out more about the Artemis Global Emerging Markets Fund and its positioning visit the fund page at www.artemisfunds.com.

 

The fund is a sub-fund of Artemis Investment Funds ICVC. For further information, visit www.artemisfunds.com/oeic. Third parties (including FTSE and Morningstar) whose data may be included in this document do not accept any liability for errors or omissions. For information, visit www.artemisfunds.com/third-party-data. Any research and analysis in this communication has been obtained by Artemis for its own use. Although this communication is based on sources of information that Artemis believes to be reliable, no guarantee is given as to its accuracy or completeness. Any forward-looking statements are based on Artemis’ current expectations and projections and are subject to change without notice.
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