Investment Update: The Case for a More Neutral Stance on Emerging Markets Equity

Jeff Mortimer, CFA, Director of Investment Strategy

COVID and the regulatory crackdown in China has taken some of the wind out of emerging market sails, prompting a more neutral view of the asset class – at least for now.

“When you cannot change the direction of the wind, adjust your sails.” I’ve long been a proponent of applying this saying to many aspects of life, whether that’s in the context of relationships, careers, or other things we cannot control. It can also apply to investing. My role as an investment strategist is to help investors navigate market cycles and build long-term wealth by providing forward-looking views of the world’s asset classes. At times, a change in fundamentals requires an adjustment of our opinion on what asset classes to favor within a well-diversified portfolio. With performance of emerging markets equity being challenged of late, it’s important to look at what’s behind the recent weakness, and whether it’s time to adjust our thinking about the asset class.

Emerging Markets Equity Performance

A lot has changed since last fall, when we recommended a modest increase in emerging markets equity exposure to a small overweight within our fully diversified balanced portfolios. This advice was based on evidence of a stronger economic recovery outside the U.S., a weakening dollar, and attractive relative valuations versus U.S. stocks. As you can see in Exhibit 1, the wind was behind emerging markets last year and into the first part of 2021. But performance has since been challenged, with the MSCI Emerging Markets Index up only 3% year-to-date through August 31. This compares with nearly 12% for international developed markets, as measured by the MSCI EAFE Index, and 22% for the S&P 500.

A closer look at the chart below reveals that China, representing some 40% of the emerging markets index, has clearly weighed down the asset class. This is not surprising given the Delta variant’s negative effect on growth and the impact of China’s recent regulatory crackdown on investor sentiment.

Exhibit 1: Emerging Markets Equity Performance

Emerging markets equity performance chart

Slowing Economic Growth

Emerging markets, and China in particular, exhibited a rapid economic recovery compared to developed economies following the initial wave of COVID-19. In fact, China’s GDP bounced back to its pre-pandemic growth trend during the fourth quarter of 2020, faster than any other country. More recently, however, we’ve seen a new wave of the coronavirus in China, as well as a tightening of its monetary policy, and a government focused on new industry regulations. Although the number of new COVID cases in developing economies – including Asia – is currently low relative to developed economies, there are concerns that the lower rate of vaccinations in emerging markets could lead to an uptick in cases and less economic activity as a result.

The slowdown in economic activity in China is already evident in recent consumption, manufacturing and services data. Chinese consumers have cut back on spending on both big-ticket items like cars as well as lower cost items like cosmetics. August's retail sales rose a disappointing 2.5% year-over-year, missing forecasts for a 7% increase. China's Caixin manufacturing Purchasing Managers’ Index (PMI) slowed further, from 50.3 in July to 49.2 in August – the lowest level since February 2020. Meanwhile, China’s non-manufacturing PMI was much weaker than expected, at 47.5 versus a consensus forecast of 52.0 and July's 53.3. It was the first contraction in non-manufacturing since February 2020.  

China’s Regulatory Crackdown

Another factor that could continue to negatively impact China’s growth is the regulatory environment. The recent wave of regulatory interventions by the Chinese government has extended beyond its decision in the fall of 2020 to suspend the Ant Group’s initial public offering. Initially regulations targeted internet/technology companies because of their monopolistic size and ability to collect data on Chinese consumers. But we’ve now seen regulatory interventions encroach on a range of industries, from online education to computer games.

The objective with these regulatory interventions is in line with China’s goal of becoming a self-sustaining economy, even if it comes at the cost of economic growth and corporate profit. That’s why we believe increased regulation represents a structural change, which needs to be considered when investing in China.

Emerging Market Positives

All that said, while a strong earnings recovery during the first half of this year has helped U.S. stocks grow into their slightly elevated multiples, emerging markets  equity continue to look cheap on a relative basis. The S&P 500 was trading at a multiple of 21.8x the consensus 12-month forward earnings at the end of August and above its 10-year average of 16.9x. At the same time, the forward 13.2x price-to-earnings multiple of the MSCI Emerging Markets Index was trading at a 39.4% discount to the S&P 500, and just slightly above its 12.1x 10-year average.

Over the longer term, we still believe strongly in emerging markets equity, although the asset class tends to be more volatile than most others, both in its returns and news flow. When we comprise our 10-year capital market assumptions every year, emerging markets equity continues to rank near the top of our list, largely due to its positive economic growth rates, favorable demographic trends, and reasonable valuations.      

Taking a More Neutral Stance

In our view, investors should continue to be well-served by having some exposure to emerging markets equity within a well-diversified portfolio. We think long-term growth opportunities remain strong, even amid the recent growth slowdown, and valuations remain attractive relative to developed equity markets.

Yet we cannot ignore the developments in China, given the country’s large weight within the emerging markets equity index. We believe China’s regulatory restrictions may represent a structural change, with the full extent of their impact on earnings growth still unknown. 

We constantly monitor factors such as economic activity, earnings growth, valuations and currency movements when assessing the relative attractiveness of domestic and international equity markets. Taking these factors together, we believe risks within emerging markets over the next 12-18 months have increased compared to a year ago, when we favored increasing exposure to the asset class to benefit from a global recovery.

Even so, we continue to believe there are attractive opportunities that skilled active managers can uncover within the asset class – we just recommend a more neutral stance at this juncture. We continue to like our overall portfolio positioning with a small overweight to equities overall and a bias toward U.S. equities and stand ready to adjust our sails to take advantage of where we see the best risk/reward tradeoffs.

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