Volatility Machines or Opportunity for the Next Decade?
The last decade was unquestionably marked by a significant outperformance of the American large corporation. Any investment strategy that strayed away from a pure and simple long allocation to the S&P 500 trailed the benchmark. However, looking forward such success might be the seed of its own demise as valuations are rich and mean-reversion might kick in.
As we investigate areas of possible future outperformance, today we look at Emerging Markets. Developing economies have had a volatile decade and have generally underperformed US equities. The volatility factor is not new as emerging Markets have always been affected disproportionally by the commodity cycle and by speculative investment flows which have often caused major issues with inflation and relative values of domestic currencies.
At this juncture, one must ask whether the old paradigm is still valid – EM as volatility machines – or if a new framework might be surfacing.
While the short-term noise might still be influenced by investment flows and old perceptions, the fundamental economic growth differentials between emerging economies and developed ones should lead to a long-term advantage in EM equities. The driving factor is relative better demographics which should be pushing emerging economies toward a normalization of their business cycle. In other words, as EM rise in per capita wealth, the role of the middle class rises, and internal demand becomes increasingly more important relative to the commodity cycle. Furthermore, the current valuation factor which prices EM equities at more attractive multiples compared to the US makes the EM case compelling.
The transition to the new paradigm is evidenced by a few data points; for example, in Asia alone, 1.5 billion people are expected to enter the middle class between 2020 and 2030 compared to only 10 million in the US (source: JP Morgan). Also, one quick look at how Emerging Markets break down by sector today compared to ten years ago provides a good context of how things are changing; in 2009 the commodity sector represented 30% of the emerging economies while now it is only 15%. On the other hand, the consumer sector has risen to 20% of the aggregate economies versus only 11% in 2009. The technology sector is also growing at 27% versus 22% ten years ago (source: FactSet. MSCI, JP Morgan).
As the middle class emerges, consumption patterns will also change. It is projected that food and beverages expenditures will drop from 54% to 35% while apparel, transport, education and housing will all see healthy increases (source: World Bank).
The annualized rate of return of EM equities over the last decade has been very low; a passive tracker such as the ETF EEM only produced just over 2% per year. However, the future might look much brighter. This might be especially true in actively managed vehicles where a local manager might be able to delve deeper into the micro-trends that will develop as emerging economies mature.
Please feel free to contact our team should you want to discuss in more details.