Emerging Market Equities Turn the Corner

November 1, 2017  | by Mark Bennett

Equities | Investment Strategy

As we progress through calendar year 2017, we have witnessed the continuation of the equity bull market started in 2009. One difference however, is that leadership has turned (finally!) to non-U.S equity markets.

On a year–to-date basis, the MSCI ACWI ex U.S. Index has returned 21.13 percent through September, ahead of the S&P 500 Index by nearly 700 basis points. Within the Non-U.S. markets, emerging markets have been the stalwart performer, advancing over 30 percent. After many years of favorable valuations, investors in EM are finally being rewarded. Why is it now that patience is being rewarded? After all, many of the world’s geopolitical problems (North Korea nuclear threat, Brazilian political corruption, Turkish religious and political movements, etc.) emanate from these markets. To put it simply, earnings are finally coming through, driving share prices higher in the emerging world. As the chart below depicts, it has been over 6 years since estimate revisions have been positive. Said differently, earnings estimates have been revised downward for six straight years, until 2017. When earnings growth is persistently overvalued, it is hard for shares to rise, no matter how attractive valuation is. The story today is different, as the earnings backdrop has improved, or at the very least stabilized, allowing competitive global relative valuations to be viewed with more optimism.

CH1-EarningsRevisionRatios_2016 Web ChartInvestors have historically held emerging market allocations because of the favorable GDP growth these developing countries experienced. This growth largely came through during the 2003-2007 time frame, when emerging markets also lead equity markets higher. Positive impacts from globalization and urbanization carried through to emerging markets growth, benefiting industrial and infrastructure dependent companies in the emerging world. Many of the beneficiaries of strong GDP growth were state–owned enterprises (SOE’s) in countries such as China, Russia and Brazil, and the make-up and characteristics of the emerging markets index reflected this. As table 1 below indicates, at the beginning of 2003 nearly 27 percent of the EM Index was made up of materials and energy stocks, with the largest of these holdings representing state-owned interests in Brazil, South Korea, and Russia. Banks also represented a large segment of the index back then at nearly 17 percent, with large weightings from China and Brazil, particularly in SOE’s. The 2003-2007 period was strong for EM equities, with 5-year annualized returns at the end of 2007 of over 37 percent. At the end of this run, infrastructure related sectors (energy, materials) grew to over 33 percent of the index, while financials grew to over 20 percent. Remember, many of the largest companies in these sectors were SOE’s, and these three sectors represented over 50 percent of the index at the time.

Table 1

At their peak, public emerging markets equities, as defined by the EM Index had characteristics of a deep cyclical stock. Commodity prices (materials and energy) and interest rates (financials) played a large role in determining year-to-year returns of this index, given the sector make-up. In retrospect, public EM equities were never a great proxy for capitalizing on the emergence or growth of a middle class in many of these economies. Admittedly, the private markets during this time have been better positioned to access the consumption growth that was so attractive in this asset class.

Fast forward nearly 10 years, and the emerging market index has changed substantially, a reflection of the latest market leadership. Today, as the table above depicts, those large weightings to materials and energy (33 percent in 2007) are much lower (14 percent today), consistent with underperformance in these two sectors over the past five years. Conversely, technology is by far the largest weighting in the index at almost 28 percent, a reflection of continued outperformance of the sector along with the listings of very large technology companies in the past few years, such as Tencent, Baidu and Alibaba. Technology, financials (banks) and consumer discretionary comprise over 60 percent of the index today and represent areas of the market that are directly related to the emergence of a middle class in the developing world, which is more consistent with the opportunity that attracted investors in the first place. The index today is now a better proxy for the attractive elements investors want to capture in the emerging markets. At Commonfund we advocate for policy portfolios that maintain broad global allocations across public and private equities to give investors an opportunity to capture these shifts in leadership without trying to time them, which we believe is exceedingly difficult to do well.

Authors

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Mark Bennett is a member of the Investment team and is responsible for evaluating and monitoring equity managers. Prior to joining Commonfund, Mark was an Investment Consultant for defined benefit services at CIGNA Retirement and Investment Services. He was an asset allocation analyst and consultant for CIGNA-Connecticut General Pension Services, Inc. Previously, Mark was a benefit technician for CIGNA Retirement and Investment Services. He received a B.S. from Bryant College and his M.B.A. from the University of Hartford. Mark is a CFA charterholder and is a member of the Hartford Society of Financial Analysts and the CFA Institute.
Mark A. Bennett
Managing Director, CFA
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Disclaimer

Information, opinions, or commentary concerning the financial markets, economic conditions, or other topical subject matter are prepared, written, or created prior to printing and do not reflect current, up-to-date, market or economic conditions. Commonfund disclaims any responsibility to update such information, opinions, or commentary. To the extent views presented forecast market activity, they may be based on many factors in addition to those explicitly stated in this material. Forecasts of experts inevitably differ. Views attributed to third parties are presented to demonstrate the existence of points of view, not as a basis for recommendations or as investment advice. Managers who may or may not subscribe to the views expressed in this material make investment decisions for funds maintained by Commonfund or its affiliates. The views presented in this material may not be relied upon as an indication of trading intent on behalf of any Commonfund fund, or of any Commonfund manager. Market and investment views of third parties presented in this material do not necessarily reflect the views of Commonfund and Commonfund disclaims any responsibility to present its views on the subjects covered in statements by third parties. Statements concerning Commonfund’s views of possible future outcomes in any investment asset class or market, or of possible future economic developments, are not intended, and should not be construed, as forecasts or predictions of the future investment performance of any Commonfund fund. Such statements are also not intended as recommendations by any Commonfund entity or employee to the recipient of the presentation. It is Commonfund’s policy that investment recommendations to its clients must be based on the investment objectives and risk tolerances of each individual client. All market outlook and similar statements are based upon information reasonably available as of the date of this presentation (unless an earlier date is stated with regard to particular information), and reasonably believed to be accurate by Commonfund. Commonfund disclaims any responsibility to provide the recipient of this presentation with updated or corrected information. Past performance is not indicative of future results. For more information please refer to Important Disclosures.