How have emerging markets evolved in the last few decades?
Much has changed since the heyday of emerging markets (“EM”) investing back in the early 2000s. In fact, from 2003 to 2007, the ‘BRIC’ economies—referring to Brazil, Russia, India and China—led one of the strongest rallies on record. Cyclical export-oriented businesses along with commodity and resource companies jumped, and the prospects of a consumer-led boom led by China took hold of markets. Although half of that BRIC acronym, Brazil and Russia, have disappointed in terms of growth over the last decade, I believe EM can still provide important cyclical value-oriented exposure, which can be additive during times of post-recession recovery. We've witnessed some of that benefit in the last 18 months from the market lows in March 2020. What has changed is the influence of Asia within EM benchmarks. And within Asia, China's become the epicenter of growth and influence followed by South Korea, Taiwan and India. As of June 30, 2021, Asia represents over 75% of the MSCI Emerging Markets Index, and the region’s growing prominence in emerging markets makes it increasingly important to get the Asia part right.
Given that emerging markets equities have underperformed the developed equity markets over the past decade, should emerging markets continue to play a role within international portfolios considering their higher volatility?
Yes, certainly in my mind, EM should play a role in investors’ portfolios. And it’s true that EM equities have underperformed during the last decade, but remember, the decade prior to that was almost the mirror opposite—EM equities dramatically outperformed the S&P 500 Index. Several factors have contributed to EM equity underperformance in the past 10 years. One prominent reason is the incredible performance of U.S. stocks during this period. Now we can all debate whether U.S. stocks will continue to deliver, however it's my opinion that EM equity’s relative underperformance may be turning around for a couple of reasons.
First, U.S. corporate earnings could come under pressure with the proposed higher corporate tax rates and the reduction of U.S. liquidity through the forecast tapering of the U.S. Fed’s bond purchasing program.
Secondly, if you believe the global economy has entered a period of economic growth with slightly higher inflation, you've just described what we've experienced several times in the last 30 years. And during those previous periods, on average, EM and Asian equities were the top asset class performers, higher even than the S&P 500 Index and MSCI EAFE Index in most cases.
Why do EM equities typically perform well in a post-recession environment?
Cyclical recoveries typically come with synchronized global growth, higher commodity prices, higher interest rates, higher earnings, and a marginally weaker dollar, which all favor the emerging markets and risk assets broadly. In my view, the current post-recession scenario, which started in the second half of 2020, may very well play out much the same as in the past.
China equities currently account for close to a 40% weighting within MSCI Emerging Markets Index. How do you think investors can overcome risks associated with China’s changing regulatory landscape?
First, I am not overly concerned about China’s outsized weighting within the MSCI Emerging Markets Index. In my opinion, most investors are underweight China by almost any metric. To put this into perspective, if a U.S. investor has 30% of their equity investments outside the U.S., and two-thirds of that is typically in EAFE (Europe, Australasia, and the Far East) or other developed market holdings, that leaves about a third in EM, which typically equates to about 4% of their allocation in China—a fairly small portion of their overall public equity portfolio.
In terms of managing risks within today’s regulatory landscape, what I would be concerned about is how investors get exposure to China outside of an active global EM investment. In my 30-years investing in emerging markets, I cannot recall a period more important to seek active management. Unfortunately, the current China equity ETFs that are available to investors have some serious shortcomings in my opinion—including being blind to the regulatory risks. I strongly favor an “all shares” approach to China. In other words, an investor shouldn't have to choose between Chinese U.S. listed ADRs, Hong Kong-listed shares or locally listed A-shares. In my opinion, investing with an active all-shares manager who can allocate amongst the various jurisdictions with an eye on corporate governance as a way to address those regulatory headwinds is an optimal method for harnessing the opportunities in China.
If an investor wanted to build a portfolio that includes emerging markets equities, how do you think it should fit into their overall global diversified portfolio?
When I speak to U.S. clients, they typically have 20% to perhaps 30% of their public equities outside the U.S., with the majority of holdings invested in EAFE, plus a small sliver in emerging markets—which usually equates to 5% to 10% of their equity holdings in EM. In my view, having 20% to 30% outside the U.S. makes sense, but I would suggest that the international allocation should be flipped. I believe the average investor has far too much allocated to EAFE, especially within developed Europe, and therefore the traditional international allocation to EAFE and global emerging markets deserves a re-think.
Why do you believe that?
I believe that investors should recognize the rapid evolution of what I would call a ‘second sphere of influence’ in global investing. The first sphere of influence is the U.S.—and probably will always be the U.S.—and the second sphere has historically been Europe. Now I would argue that the drivers of international returns are moving east and they're moving east very quickly. I believe the second sphere of influence is now Asia, specifically Asian emerging markets. It's not only because of the massive size of these economies or the growth of their capital markets. What I am seeing is that Asian companies have more attractive fundamental metrics in aggregate. For example, historical three-year earnings per share (EPS) growth has been higher in Asia than Europe. Additionally, historical, three-year sales growth has been higher, forecasted EPS growth is higher in Asia, and return on equity is currently higher, while equity valuations in Asia are lower than EAFE. So, I believe an investor’s international allocation should be closer to one-third in developed-market Europe and two-thirds Asia and emerging markets—how investors slice up their Asia and emerging markets depends on their current holdings and risk tolerance.
What is your outlook for emerging markets over the next one, five or 10 years from now?
First, I would say that one year from now we likely will not be talking about Chinese regulation in the same way, as the severity and cadence of the recent Chinese regulatory headlines may have peaked. Going forward, I believe that company fundamentals will outweigh macro-related headwinds in China. Now overall, I believe that EM is compelling over the short term, and that's because of its exposure to the cyclical recovery.
The next five to 10 years looks fairly compelling as well. One important reason is improving corporate governance and transparency. The recognition of shareholder rights continues to improve, putting a larger share of profits into shareholder pockets. Furthermore, EM companies have shown robust profitability and not just in times of cyclical recovery. EM companies, especially those in South Korea, Taiwan, China, and non-Asian countries like Brazil, can be very profitable, rivaling companies in developed markets.
Going forward, what do you think will be the key investable theme within emerging markets?
In my view, capturing innovation will be an important theme—investing in companies and sectors connected to innovation, especially those in China and other North Asia countries. Now I have to admit innovation sounds like a bit of a cliché or a passing fad, but in reality, innovative sectors such as information technology, health care, communications services and consumer discretionary have been the best performing and largest contributors to Asia and emerging market returns over the long term.
As allocators, we always need to ask ourselves, will this investable trend continue? I think it will. In fact, I think that the innovation theme in Asia is just beginning. Asia's stage of innovation today compares to what the U.S. was like in the 1970s to 1990s. Imagine if you could have purchased innovative U.S. companies such as Microsoft, Genentech and Apple back in the 1990s. We believe Asia's current stage of development, buying power, and consumer preferences all point to a very similar path of demand for innovation. Therefore I believe that finding an active manager focused on EM and Asian innovation should be at the core of every emerging market allocation today.
Investing in emerging markets involves different and greater risks, as these countries are substantially smaller, less liquid and more volatile than securities markets in more developed markets. Securities denominated in a foreign currency are subject to the risk that the value of the foreign currency will increase or decrease against the value of the U.S. dollar.
All investments involve risk. Past performance is no guarantee of future results. Investing in Chinese securities involve risks. Heightened risks related to the regulatory environment and the potential actions by the Chinese government could negatively impact performance. Investing in international and emerging markets may involve additional risks, such as social and political instability, market illiquidity, exchange-rate fluctuations, a high level of volatility and limited regulation.
As of June 30, 2021, portfolios managed by Matthews Asia did not hold Microsoft Corp., Genentech or Apple.
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