The emerging-market equities team has been focused on two aspects of index performance and their impact on the outlook for stocks. The first is the increasing concentration of Chinese stocks in the MSCI Emerging Markets Index and the second is the extreme underperformance of emerging-market value stocks relative to growth stocks.
The concentration of the benchmark has become a much discussed topic, as the inclusion of China A shares means that China’s weight in the MSCI equity benchmark has surpassed 40% and is set to reach 57% in 2027, according to MSCI forecasts. In addition, the weight of the 10 largest constituents in the 1,400-member emerging-market benchmark has increased from below 15% in 2015 to over 30% today, with eight of them being Chinese. Investor discussions continue about the creation of an emerging-market benchmark that excludes Chinese stocks.
The second development that we want to point out is the huge variation in performance among emerging markets this year. While markets in China and Taiwan have risen about 30% so far in 2020, Brazil and Chile are down about 30%. Moreover, traditional growth sectors such as Information Technology, Consumer Discretionary (the sector that e-commerce calls home) and Health Care have outperformed significantly versus traditional value sectors such as Energy, Materials and Financials. As a result, emerging-market value stocks have underperformed growth by 40%. If valuation history is any guide, it is likely that value stocks will perform strongly going forward.
MSCI Emerging Markets Index Equilibrium
Normalized earnings and valuations
Note: Fair value estimates are for illustrative purposes only. The bands’ boundaries capture one standard deviation of movement above and below this estimate. Corrections are always a possibility and valuations will not limit the risk of damage from systemic shocks. It is not possible to invest directly in an unmanaged index. Source: RBC GAM
While we can make a strong case for value stocks, we believe the market will continue to move back and forth between the growth and value styles depending on where we are in the recovery. In addition, we feel that the outperformance of growth can be ascribed to fundamental reasons such as earnings growth and balance-sheet strength. For example, in the past decade, index-level earnings for the MSCI emerging-markets benchmark have been flat, and all the growth in earnings has come from technology stocks.
In emerging markets, it is clear that the stock markets of countries that have done a good job controlling the coronavirus are outperforming. China, Taiwan and South Korea, which account for two-thirds of the emerging-markets index, have all but eliminated the virus within their borders and are reaping the benefits of superior stock returns relative to equity markets such as those in India, South Africa and Brazil. Given that emerging markets have as a whole spent less than 5% of GDP on coronavirus-related fiscal stimulus compared with about 30% for developed markets, there is the potential for fiscal stimulus should it be required.
Clearly we might now be about to see a major reflation as deglobalization and higher fiscal expenditures likely result in faster inflation and GDP growth after decades of falling money velocity. During periods of reflation, equities tend to outperform bonds and emerging markets generally outperform developed markets. Also during times of reflation, we can expect classic value sectors such as Financials, Materials and Energy to perform solidly.
E-commerce and health care are key industries that have benefited from the COVID-19 pandemic. Consumer behaviour changed irrevocably and we can expect long-term trends in place before the pandemic to accelerate their earnings.
While e-commerce has clearly taken off, adoption accelerates when the percentage of retail transactions handled online reaches 5%. China and South Korea already have online adoption rates in the range of 35%, and many emerging-market countries are about to enter this hyper-growth phase in e-commerce. India, Mexico, Russia and Brazil have much lower levels of penetration, but all have reached the 5% threshold.
Furthermore, trends in the emerging-market Health Care sector are very supportive as emerging markets as a whole spend 5.6% of GDP on health care, compared with 12.5% in developed markets. We expect, therefore, that the rising affluence of expanding emerging-market middle classes will bolster further outperformance in the sector.
We expect emerging-market earnings to rebound over the next two years after three years of weakness.
Earnings projections are hard to forecast at the moment, and we therefore prefer to look at price-to-book (P/B) as a valuation measure. On this metric, the MSCI Emerging Markets Index is trading at 1.7 - in line with the historical average and at a 35% discount to developed markets.
Emerging-market earnings tend to rotate between long periods of under- and outperformance, largely based on broad U.S.-dollar trends. Emerging-market stocks generally rise when the U.S. dollar declines, and vice versa, correlations we can see in four periods dating to 1988. We are just coming out of a decade of underperformance for emerging-market equities and U.S.-dollar strength, and we believe this is about to reverse. We can see the case for a weaker U.S. dollar, which is positive for emerging markets as they have US$5.4 trillion of debt denominated in U.S. dollars and other developed-market currencies. Supporting emerging-market currencies are strength in the Chinese renminbi, inventory restocking, a relatively low oil price and an upswing in technology usage.