by Tim Love – Investment Director
The first quarter of 2022 was even more eventful than last year, with two material geopolitical events – the Russian invasion of Ukraine, promptly followed by investors indiscriminately selling out of Chinese ADRs. Despite this, we feel there are a number of compelling reasons to consider emerging market (EM) equities.
Attractive earnings expectations
Despite the higher beta of EM equities year-to-date, we believe their strong fundamental GDP and valuation supports, plus their earnings per share (EPS) resiliency, is likely to be supportive of this asset class. For instance, compare the S&P 500’s current forward price to earnings ratio (PER) of 19x to the Hang Seng China Enterprises Index’s significantly lower PER of 7.5x or the MSCI EM’s PER of 9.8x, as at 21 April 2022. We believe this is a clear illustration of how under owned, under loved and undervalued the asset class has become.
The changed composition of the emerging markets index
The MSCI EM index has morphed considerably in recent years. Once a collection of non-investment grade countries, it is now composed of a group of liquid, laggard investment grade markets, with lower credit risk, appealing to value, growth and yield investors.
As of 27 April 2022, South Korea, Taiwan, India and China account for approximately 69% of the index between them, followed by 20% from Saudi, South Africa, Brazil and Mexico. Add in the Gulf (Qatar and Bahrain), Thailand and Philippines and that is almost the entire index. In other words, Turkey, Russia, Venezuela, Peru, Colombia, Argentina, Romania, Hungary, the Baltics, Pakistan, Vietnam and all of Africa (with the exception of South Africa), which are considered riskier, make up less than 1% of the MSCI EM Equity index.
Attractive risk/return profile compared to developed markets
Helped by both EM valuation support and the change in the composition of EM, the risk / return quadrant for EM equities looks attractive compared to developed market (DM) equities, in our view.
Perhaps counterintuitively, EM equities outperformed most DM equities in the first quarter of this year – despite the convulsions within the asset class following Russia’s invasion of Ukraine and the indiscriminate sell-off of Chinese ADRs around delisting fears.
Over the long term, we believe EM not only has less far to fall relative to DM, but also that EM has more upside than DM, given EM markets have significantly de-rated over the last 15 years. Indeed, EM valuations are currently close to 2004 levels, after which we saw a period of strong outperformance relative to DM.
Improving ESG credentials
Given EM countries account for more than half the world’s GDP and two thirds of its landmass, its environmental, social and governance (ESG) footprint could not be more important. We are seeing significant improvements in ESG considerations in the key emerging markets, for example China, South Korea, Taiwan and India, and we believe this may continue. As a consequence, we believe EM may offer benefits to those investors willing to engage and foster that potential change and ratings uplift.
China as a means of further upside
We cannot talk about EM without acknowledging the importance of China, which now accounts for 27.6% of the MSCI EM index as of 27 April 2022.
With concerns over China’s passive involvement in the Russia-Ukraine conflict, China’s index hit an all-time low in mid-March 2022. However, this was followed by the biggest one-day rebound ever seen for Chinese shares. This was fuelled by China Vice Premier Liu He’s speech, in which he addressed key market concerns around stabilising the property market, dealing with the US ADRs issue and providing clarity on technology regulation. Should China back up its commentary with real actions, we believe current market levels look likely to be an absolute low, or at least a relative one. We see potential opportunities in policy aligned areas, including technology software, the electric vehicle production chain and renewables, such as solar.
Clearly then, in our view, the road has been far from smooth for investors in EM equities over the last 15 years and, as a result, the asset class has drifted off the radar of many investors. Despite recent volatility, we see cause for optimism and believe EM equities may potentially offer opportunities for active investors. Year to date, that has been demonstrated on a relative basis to DM. If we are right, we believe it could manifest itself in an absolute outperformance as well.
