Emerging-market equities have a bad rap. But a lost decade may have set up promising conditions for a recovery.
After a difficult year in 2023, we’re seeing signs that a recovery may be brewing for emerging-market (EM) equities. For investors to regain confidence, it’s important to revisit some common assumptions about EM stocks with a critical eye.
It’s easy to understand why investors are struggling to warm to EM. The MSCI Emerging Markets Index rose 9.9% in US-dollar terms in 2023, trailing far behind the S&P 500, which rallied by 26.3%. Last year’s returns capped a decade of weak performance that cemented negative investor sentiment toward EM equities. But we think some of the biggest concerns are rooted in misconceptions.
Misconception #1: US Stocks Always Beat EM Stocks
Some investors may be surprised to discover that US and EM stocks have delivered similar annualized returns since the inception of the MSCI EM 23 years ago (Display). Since 2001, the S&P 500 and the MSCI EM posted annualized returns of about 7.8% and 7.6% respectively—stronger performance than developed markets outside the US.
Of course, EM equity markets have delivered disappointing returns over the last 10 years. But rewind further to the first decade of the 21st century, and EM stocks outperformed the S&P 500 by a wide margin. Over the longer run since 2001, EM stocks have outpaced the MSCI World.
Last year’s headline market performance obscured some encouraging underlying trends. US equity returns were driven primarily by the so-called Magnificent Seven, a small group of mega-cap stocks that were seen as the big winners from the artificial intelligence (AI) revolution. Yet beyond the Magnificent Seven, the broader equity market didn’t perform nearly as well. And EM stocks were weighed down by sharp declines in China. But excluding China, EM stocks returned 20.1% in 2023 (Display), with equity markets in some countries such as Poland, Greece and Mexico posting stellar performance.
These trends could change. We believe that US market concentration has been historically extreme and could eventually broaden. Sentiment toward China may improve over time as policy support kicks in to the economy. But last year’s challenging conditions in global markets are a reminder that US and EM equity return patterns are more complex than meets the eye.
Misconception #2: There’s No Earnings Growth in EM
EM earnings growth has indeed been weak over the past decade. Companies have faced many hurdles, including a stronger US dollar, which eroded USD earnings-per-share (EPS) growth for EM companies, and intensifying geopolitical concerns, from the US-China trade wars to Russia’s invasion of Ukraine.
Yet we believe that several trends could create a much more favorable environment for EM companies in the decade ahead. Innovation, reshoring efforts by global manufacturers and the global push for climate resilience are growth drivers that will benefit select EM countries and companies, in our view. In fact, EM EPS growth is projected to be relatively strong over the next two years (Display).
Earnings revisions also offer hope. In the fourth quarter of 2023, consensus EPS growth estimates for the next 12 months were revised up by 5% for the MSCI EM, compared with 1.3% for the S&P 500. In our view, this provides tangible evidence of a turn in fundamentals that may signal an inflection point for EM versus US equity returns.
The distribution of EPS growth rates in EM points to unrecognized opportunity, in our view (Display, above). Our research shows that companies growing earnings by at least 10% a year or more represent more than half the index in EM. And a higher proportion of the EM index weight is in companies with more than 30% EPS growth, when compared with the US market. What’s more, by the end of 2023, the MSCI EM traded at a price/forward earnings valuation of 11.7 times, a 39% discount to the MSCI World.
To be sure, the EM index has more exposure to sectors that are vulnerable to macroeconomic swings. However, the EM benchmark includes 1,441 stocks, offering a diverse opportunity set. In fact, in the MSCI All-Country World Index, EM stocks account for only 10.4% of the benchmark weight but 49% of the 2,921 names. In other words, there’s a big pool of EM companies for active managers to create portfolios that strike a healthy balance between strong earnings growth potential and features that help reduce cyclical volatility.
Misconception #3: EM Is All About the Chinese Economy
China was a big part of the EM growth story from 2001 to 2010, and its weakening macroeconomic growth has grabbed headlines in recent years. However, 75% of the MSCI EM’s weight is outside of China. And a higher share of innovation comes from other regions in East Asia, where many hardware suppliers manufacture key components to enable AI. We call this “backdoor AI,” as it allows investors to participate in AI growth at much lower valuations than that of US-listed leaders.
Meanwhile, reshoring outside of China should benefit EM countries such as Mexico, India and countries in Southeast Asia. And the rise of India, with its plentiful labor pool, offers a long runway for growth.
Commodities including hydrocarbons may, perversely, become more precious as environmental constraints limit supply. This will benefit commodity-rich countries such as Brazil, Saudi Arabia and the UAE. Saudi Arabia’s Vision 2030 plan to diversify its economy will also create opportunities for equity investors, in our view.
Within China, a new paradigm is emerging. China is in transition to an economy with healthier sources of more sustainable growth. Despite recent underperformance, we believe that investors can find select companies in technology, medical, consumer and industrial sectors that offer solid growth potential, yet are not yet household names to international investors—and offer attractive valuations.
Investor apprehension toward EM equities is understandable. Yet a fresh look at the historical record as well as future drivers of growth reveal an EM equity landscape offering diverse sources of opportunity that are hidden in plain sight.
- Sammy Suzuki
- Co-Chief Investment Officer—Strategic Core Equities