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Breakingviews - Unloved emerging markets are due a revival
LONDON, June 12 (Reuters Breakingviews) - Investors in emerging market stocks get biblical returns. Seven years of plenty are often followed by seven lean ones. The recent experience has been a great deal worse. By the start of this year, developing markets had delivered 15 years of disappointment. The good news is that the conditions are ripe for emerging equities to recover some of their lost ground.
The group of countries that we now call emerging markets were a complete washout in the first half of the 20th century, largely due to war and the expropriation of shareholders by Communist governments in Russia and China. Since the 1950s, they have earned 6.7% a year in real terms, measured in U.S. dollars. That's in line with the average returns of developed markets. These returns have been lumpy, though: emerging markets delivered 9.5% a year in the 1980s, 3.4% annually in the 1990s, and 8.4% in the 2000s, according to UBS. From 2010 to the start of this year, dollar returns were just 1.3% a year, after inflation – the worst performance since the 1940s.
At the start of this disappointing run, investors' expectations for this asset class had never been more ebullient. Antoine van Agtmael, the former World Bank economist who coined the term 'emerging markets' in 1981 after being told that a proposed Third World Equity Fund would never catch on, was proclaiming the 'Emerging Century'. Goldman Sachs was touting the rapid economic growth of the so-called BRIC countries: Brazil, Russia, India and China. Whereas the developed world was mired in aftermath of the global financial crisis, emerging markets escaped largely unscathed. Commodity prices rocketed. Capital flows into emerging markets soared.
At the height of this euphoria the lean period commenced. In 2011, commodities markets turned down. Foreign capital inflows reversed after the U.S. Federal Reserve's announcement of monetary tightening sparked a 'taper tantrum' in 2013. Brazil, India, Indonesia, South Africa and Turkey, which were dubbed the 'fragile five', hit the buffers. In 2014, investigators exposed widespread corruption at Brazil's state oil company Petrobras, which not long earlier had persuaded investors to buy into the world's largest secondary share offering.
Emerging stocks remained in the doldrums for the rest of the decade. Their fortunes turn down again in 2022 following Russia's invasion of Ukraine. After Western governments imposed sweeping sanctions on the country led by President Vladimir Putin, foreign shareholders in Russia found themselves once again holding worthless pieces of paper. Around the same time, China's real estate bubble imploded and President Xi Jinping launched a crackdown on large tech companies. By the start of this year, the share of emerging markets in the global stock markets had shrunk to 10%, less than half the combined market capitalisation of the 'Magnificent Seven' U.S. tech stocks.
Revulsion against emerging markets was so severe that some called for the label to be dropped. John-Paul Smith, a former emerging-market specialist strategist at Deutsche Bank, declared, opens new tab that it was not a viable asset class, as the 24 countries spread across four continents that make up the MSCI Emerging Markets Index have little in common. The earlier assumption that these markets were converging towards western norms of corporate governance had been proven false. The emerging markets moniker, in Smith's view, was simply a marketing tool that allowed the financial services industry to charge higher fees.
There are grounds for believing, however, that the forces that depressed returns for emerging markets are dissipating. In a recent note, the investment strategist Gerard Minack of Minack Advisors argues that the high profitability of emerging market companies in the early 2000s attracted excessive investment. Their share of global capital spending climbed from below 4% in 2000 to 11% by 2011 and remained elevated for several years. This splurge hurt profits. By the middle of the decade, emerging markets' return on assets had fallen to 3%, roughly a third of its level a decade earlier and below that of the developed world.
High capital spending combined with falling returns on investment resulted in companies issuing more shares, which in turn depressed growth in earnings per share (EPS). Between 2000 and 2011, the EPS of listed emerging market companies grew by 17% a year. Over the next 14 years, annual EPS growth collapsed to 2.3%. China was the prime culprit, says Minack, but the trend holds true for emerging markets beyond the People's Republic. The tide is now turning. Emerging market companies have reined back investment. Last year, their net capital spending (as a share of assets) was down more than 70% from its peak, according to Minack. As capital spending drops, EPS growth has started to pick up.
Emerging markets are also a potential beneficiary from the end of 'American exceptionalism' in global financial markets. The extraordinary gains in the U.S. stock market since 2009 sucked in foreign capital and crowded out other bourses, including those in emerging markets. Since Donald Trump returned to the White House, foreign investors in the United States have started to get cold feet and are beginning to look elsewhere. The U.S. president is actively courting a weaker dollar, which generally benefits emerging markets, as it did in the early 2000s. Emerging markets should receive a further fillip if the Federal Reserve cuts interest rates again.
Emerging markets currently trade at attractive valuations. Rob Arnott of Research Affiliates forecasts a potential real return of 8% a year (in U.S. dollars) over the next decade. Value stocks in those markets should do even better. Relative to the U.S. stock market, emerging markets are close to the lows of 2000, when their last bull run commenced. Over the following decade, emerging market stocks beat their U.S. counterparts by around 10% a year, after inflation.
One person who hasn't lost faith is van Agtmael. The heterogeneity of emerging markets is a strength rather weakness, he says, since it provides opportunities for diversification. Besides, his original investment case was never based on the markets' superior GDP growth. Rather, it was because he found many neglected world-class companies selling at attractive valuations across less-developed economies. That remains the case today. 'If people don't like an asset class, it's probably a good investment,' the father of emerging markets concludes.
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