Thursday, August 4, 2022
Prospects for a burst of growth in China once the reopening occurs has been a tempting investment thesis for emerging markets (EM) as much of the rest of the world has already reopened. But as we wait for that event, it’s clear we may be waiting a while longer. Meanwhile, House Speaker Nancy Pelosi’s trip to Taiwan and ongoing war in Ukraine have made it more uncomfortable to advise investors to hold anything more than a small emerging market (EM) equities allocation in portfolios. Remember, China composes roughly one-third of the MSCI EM Index. Add Taiwan and the total is near half.
“We’re all for international diversification over a long-term strategic time frame,” according to LPL Financial Chief Equity Strategist Jeffrey Buchbinder. “But it’s really tough to advocate for that right now tactically as the economic and geopolitical environment worsens outside the U.S. The strong dollar doesn’t help.”
As shown in the LPL Chart of the Day below, the days of booming economic growth for emerging market economies have long passed. Historically, faster growth in EM countries has generally been accompanied by relatively good EM stock performance compared to developed markets (DM). COVID has been an unwelcomed equalizer, leading to very similar economic growth this year in all of these markets. Meanwhile, China’s economic transformation to more of a services economy and away from low-value manufacturing and massive infrastructure spending has also shrunk this gap.
Though an EM economic growth premium will likely return in 2023 with EM likely to outgrow DM by a fairly decent margin, the geopolitical risk that comes with EM investing suggests caution is prudent.
The earnings outlook in EM isn’t particularly enticing for investors either. As shown in the next two charts, estimates for EM have been revised sharply lower since Russia invaded Ukraine. That leaves EM earnings growth lagging the U.S. and likely developed international as well over the next 18 months. The more than 10 percentage point haircut is not just Russian earnings coming out of the index (though that’s part of it). Also consider EM’s track record of meeting earnings estimates over the last decade has been spotty.
Lastly, technical analysis also tells us that the outlook for EM may be weakening. Not only is the index setting lower lows and lower highs, as shown in the top panel of the chart below, but relative strength of the MSCI EM Index compared with the S&P 500, shown in the bottom panel, is also in a downtrend that is at risk of breaking below prior lows.
So what is there to like about EM? Besides a possible but long-awaited reopening in China, valuations are the big positive here. EM is trading at a 37% discount to the S&P 500 Index on forward price-to-earnings ratio (P/E) basis (using the consensus earnings per share estimate for the next 12 months). The 15-year average discount is just 23%. Valuation is not enough to recommend an investment in our view but it sure helps in this case.
In summary, the lack of a big economic growth advantage, earnings weakness, and deteriorating technical analysis signals suggest being on the cautious side of neutral despite attractive valuations and an eventual reopening in China. Add to that heightened U.S.-China tensions and war in Ukraine and the risk-reward in EM is not as attractive to us as it was earlier this year. For those who wish to allocate to EM equities, we would encourage using active management to help navigate geopolitical and governance risks.
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