The Future of Emerging Market Equities

30 Mar 2017

  • Investors have been dismayed by the under-performance of emerging market (EM) equities compared to developed market (DM) equities over the last several years.
  • Is the recent rebound in relative performance structural or just temporary mean reversion?
  • Many worry that the end of the commodity super-cycle and the slowdown  in China signal lacklustre results for emerging market equities as a whole over the long-term.
  • In fact, the perception that emerging market equities are more dependent on commodities than developed markets is overestimated, and in China a transition to a more efficient and balanced economy should offset a deceleration in export and GDP growth in relation to equity prices.
  • Higher productivity growth, structural reform, an expanding middle class, urbanisation, and maturing capital markets all suggest the outlook for emerging market equities remains bright.

INTRODUCTION

Misperceptions

There are two criticisms of emerging market equities currently: one, that they are simply a commodity play and the commodity super-cycle peak will not be revisited anytime soon; and two (which is in fact related to one), that emerging market growth depended principally on China and now that China has become a more mature, middle income country, economic expansion will be appreciably slower in the future.

The first concern, that emerging markets are disproportionately exposed to commodities, turns out to be inaccurate. Compared to the all capitalisation MSCI World IMI (Investible Market Index), the MSCI Emerging Markets IMI is no more exposed to the energy and materials sectors. In fact, the highest relative exposure is to the high-growth technology sector, while the biggest underweight is to the defensive health care sector (see Figure 1). So all things equal, the sector makeup of the emerging market equity indices suggest greater potential returns.

One weakness in this argument could be that while EM equity markets may not be disproportionately commodity-exposed, the overall economies are. That is, the demand for consumer goods is still dependent on energy and materials prices if a large share of the economy is made up of commodity-related sectors. Again this turns out largely not to be the case. Comparing the major countries making up the respective MSCI indices, the mining sector in emerging markets is indeed twice as important as it is for developed markets, but it is still quite small; mining makes up just 3.5% of emerging market economies’ GVA (gross valued added) compared to 1.7% for developed markets. The mining sector is swamped, however, by the dominance of the manufacturing and service sectors. Manufacturing does make up a relatively larger share of emerging markets economies, but for both developed and emerging markets, the services sector is much more significant.

Despite the modest exposure to the energy and materials sectors, it is true that equity market performance over the last 15 years has been dominated by these sectors. This phenomenon is not limited to emerging market equities, however. Developed market equity indices have seen similarly wide moves for the energy and materials sectors compared to the other parts of the market (see Figure 3). The end of the commodity super-cycle likely means less volatility in emerging market equities, but this is also true for developed market equities.

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