Emerging markets (EM) have spent more than a decade in the shade of developed equities counterparts despite a few false dawns along the way.
EM advocates, however, remain ever convinced that the asset class will have its time in the sun… soon.
Henry Mallari-D’Auria, Ariel Investments CIO global and emerging markets, is among the faithful who hold fast to the notion that economic and demographic fundamentals combined with entrepreneurial energy will ultimately be expressed in EM equity outperformance.
But patience is required.
“EM versus DM [developed markets] performance has a history that moves over very long cycles… decades even,” Mallari-D’Auria said.
If EM share indices have been back-pedalling relative to US markets, in particular, they also enter the next hill-climb stage carrying lighter valuations than the tech-heavy stocks heading the pack in the S&P 500.
In its December quarter update to investors in the Ariel EM funds (two recently launched strategies including one ex-China vehicle), Mallari-D’Auria notes the “bull case” for the asset class is “ever more compelling” on the back of forecast earnings growth of 19 per cent annually for 2024 against 11 per cent for the S&P 500: at the time, the MSCI EM index was trading at 11.8-times forecast earnings versus almost 20 per cent for US stocks.
“We see meaningful upside potential, underpinned by a powerful combination of heavily discounted valuations and accelerating earnings, with an additional kicker from a likely weakening of the US dollar,” the March quarter Ariel EM fund update says.
Regardless of low valuations and historical trends, investors remain underweight EM shares, according to a State Street Global Advisors paper published this April.
The State Street report cites data showing EM stocks represent about 9 per cent of investor portfolios while the underlying markets represent 35 per cent of nominal global GDP and “the majority” of world economic growth.
“We believe this underweight is due to the fact that although EM economies have continued to outgrow their DM peers post the Global Financial Crisis, EM equity markets in aggregate have lagged DM over the same period,” the study says.
Like Mallari-D’Auria, the State Street report notes that while EM indices are at a low ebb, over “the medium to long term, emerging markets have delivered returns on a par with, if not better than, their developed market counterparts” with strong economic underpinnings to stage a comeback.
The EM sector has also evolved considerably during its brief history.
“When the MSCI EM Index was first introduced in 1988, it represented 10 economies. Each of these could be roughly characterized as ‘underdeveloped but growing rapidly’,” the State Street paper says. “By the end of 2023, there were 24 economies reflected in the Index, and there is a healthy debate over whether some of its constituent economies, capital markets, and infrastructures are too mature to even qualify for the ‘emerging’ label.”
However, investors hoping for EM index outperformance may still be disappointed.
“… the poor transmission of GDP growth into indexed equities’ performance requires investors to look beyond indexing to realize the full scale of EM opportunity,” the State Street report says.
Mallari-D’Auria agrees the EM space suits an active approach in a sub-universe where the median manager of whatever style – growth, core, value etc – “all have premiums”.
The Ariel EM portfolios, for instance, typically hold about 60 stocks out of a potential pool of approximately 1,250 companies the manager considers – a group that includes some lumped under the ‘frontier’ definition by indexers.
He said the firm’s core EM fund also has an overweight to the “unloved” China market, which has fallen out of favour in the last couple of years amid a property crisis, growth concerns and geopolitical tension.
The March quarter Ariel EM strategy update says: “We believe China offers significant return potential powered by innovation under-appreciated and overly discounted by global investors. The myopic focus on real estate pressures, geopolitical tensions, and an aging population ignores a transformation that will propel economic growth in both China and the rest of the world over the next decade. At today’s prices, investors can get this growth for next to nothing.”
Chinese stocks equate to almost 40 per cent of the Ariel core EM portfolio. Outside China, Ariel has placed its biggest EM exposures in semi-conductor companies (the Taiwan chip-maker, TSMC, for example) and South Korean financial stocks.
In total, Mallari-D’Auria said the Ariel EM funds invest across about 14 jurisdictions, although the investment process is led by company-specific factors and valuations rather than country weights.
He said institutional investors have lately shown more interest in making specific allocations to EM instead of the typical approach of gaining access to the sector via global diversified funds.
With the ongoing ‘mag-7’ enhanced rally in US stocks, though, EM funds may have to wait a while longer before investors see the light.
Mallari-D’Auria, however – who was across the Tasman last month just six months after his first visit to Australia and NZ in Ariel colours – is confident capital will once more flow to EM as the long cycle turns.
He joined Ariel – a value manager established in Chicago by John Rogers – early last year following a 27-year stint at AllianceBernstein (now known as AB).