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Three reasons why emerging markets could go back to outperforming

09 March 2020

The past decade has been difficult for emerging markets, but M&G Investments’ Michael Bourke believes the coming 10 years could be much more positive.

By Gary Jackson,

Editor, Trustnet

There are three main reasons why emerging market equities could start to outperform the developed world over the next decade, according to M&G Investments’ Michael Bourke, after an extended period where they lagged by a wide margin.

Over the 10 years to the end of 2019, the MSCI Emerging Market index posted a total return of 74.93 per cent (in sterling terms) – underperforming the developed markets-focused MSCI World by more than 125 percentage points.

Bourke, lead manager of the £664.2m M&G Global Emerging Markets fund, pointed out that Asia is the only emerging market region to make a positive return over this time, while Latin America and Eastern Europe, the Middle East and Africa have had something of a “lost decade”.

Performance of indices between 2010 and 2019

  Source: FE Analytics

“The sustained underperformance of emerging markets has framed a lot of investor thinking today,” he added. “As a result, we believe emerging markets are under-represented in investors’ portfolios. This is borne out by the consensus positioning of global fund managers who remain significantly underweight emerging markets equities.”

The last decade is in stark contrast to the previous 10-year period, however. Between 2000 and 2009, the MSCI Emerging Market index was up 240.06 per cent while the MSCI World’s total return stood at just 3.97 per cent.

In the 2000s, China was given membership of the World Trade Organization and Asia assumes a central role in global manufacturing processes on back of increased globalisation, bolstering the performance of the asset class.

At the same time, commodity producers in Latin America and Africa benefitted from growing demand for raw materials from Asia, ushering in the so-called commodities super cycle.

“After struggling in recent years, is it possible that in the next decade emerging markets equites might return to their former winning ways?” Bourke asked.

“Although there are notable differences between emerging markets equities today and in the 2000s, at present, we are optimistic about the outlook for the asset class. In three key areas – earnings, corporate behaviour and valuations – we believe the trends in emerging markets are encouraging and could support future outperformance.”

Starting with earnings recovery, the M&G Global Emerging Markets manager noted that global economic growth during the past decade was “muted” and demand was therefore weaker. Businesses in emerging markets, especially Asia, found this to be a challenging environment, contributing to lacklustre market returns.

This is because Asia is a ‘high-turnover’ region, as many of its companies make products that have slim margins and therefore need to produce a high volume of goods. These businesses struggle in an environment when demand is slowing but in the past have tended to continue investing heavily despite this, harming profitability.

“We believe the situation is different today,” Bourke continued. “Global economic activity looks to be picking up, notwithstanding trade wars and epidemics, and we are seeing companies spending less on investment. As a result, for the first time in a long while, earnings growth at emerging markets companies is expected to exceed that at developed markets companies.”

Emerging markets’ earnings recovery

 

Source: M&G, JP Morgan, Dec 2019

In addition, earnings per share (EPS) at many developed market companies have been buoyed by share buybacks – especially in the US – which has helped to inflate their stock prices. The opposite has happened in emerging markets, where companies have tended to issue new shares.

“For emerging markets equities to outperform their developed markets counterparts, they need to deliver superior EPS, as they did back in the 2000s,” the manager said. “Given the indications that the decline in emerging markets earnings is coming to end, we are hopeful that the brighter earnings picture could well lead to this outcome.”

When it comes to corporate behaviour, Bourke argued that there has been a “significant change” in attitude at many emerging market corporates in recent years.

While they adopted a ‘growth mindset’ for much of the past – borrowing heavily to fund expansion – many appear to have “learned their lesson”. As a result, corporate leverage in emerging markets has started falling as companies pay back debt while capital expenditure has come down, leading to rising cashflows.

“With companies generating more cash, we are seeing increased returns to shareholders and growing dividend payouts, particularly in markets like Russia and South Korea,” the M&G Global Emerging Markets manager said.

Finally, Bourke believes the extended period of underperformance has left emerging market equities attractively valued as they currently trade at a discount of around 30 per cent to developed market stocks. He argued this is “excessive and does not reflect company fundamentals”, instead reflecting macroeconomic concerns.

However, the manager added that he thinks the best way to approach emerging markets is with a value mindset, rather than following the growth style. The past few years have seen investors pile into higher-quality stocks offering reliable growth and profits, while ignoring value names.

“We think this is a result of risk aversion rather than fundamentals. Investors have been paying very rich multiples for the perceived ‘safety’ that growth stocks offer. However, given that expectations of future returns for these companies are so high, there is a real risk that they could disappoint. With such lofty valuations, they are also potentially vulnerable to a reversal if the outlook becomes more positive,” he explained.

“On the other hand, we believe the expectations for unloved value stocks are so pessimistic that it wouldn’t take much for them to deliver a positive surprise. On a risk/reward basis, therefore, we think that value stocks are a very appealing prospect currently.”

In the search for value, the manager has a preference for unloved parts of the market – liking Mexico, where concerns about the macroeconomic environment has created mispriced stock opportunities, and South Korea, which has suffered as the global economic outlook soured.

At the same time, he is wary on India. Although this is a popular market with investors, this has bid up prices and the manager said it is now difficult to find attractively valued opportunities.

Performance of fund vs sector and index under Bourke

 

Source: FE Analytics

Bourke has managed the M&G Global Emerging Markets fund since 1 October 2018, over which time it has made a 2.72 per cent loss. It has an ongoing charges figure (OCF) of 0.95 per cent and is yielding 2.43 per cent.

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Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.