Month: October 2023

Why do Emerging Market Stocks Underperfom?

The earnings crunch suffered by emerging markets over the past decade (EM has an Earnings Problem) has been the cause of the dramatic underperformance of the asset class relative to U.S. stocks. Poor EM earnings have resulted from cyclical factors typically affecting all economically sensitive assets, such as commodities and industrial cyclicals. Furthermore, factors specific to the U.S. market have also contributed significantly to the outperformance of U.S. stocks. Most importantly, the flourishing of quasi-monopolistic technology giants (e.g., FAANGs, the Magnificent Seven, and a few others).

The chart below shows USD-denominated earnings for Emerging markets and the three principal U.S. indices: the S&P500, the Dow Jones Industrial, and Nasdaq. The data starts in 1986, which is the year that MSCI launched its institutional index for EM. Not surprisingly, periods of EM outperformance (1986-1996 and 2002-2012) are also periods of relatively strong EM earnings growth underpinned by a cycle of USD weakness. EM dollarized earnings grew in line with the S&P500 from 1986 to 2012. Since 2012, EM earnings have trended down by 7%, while U.S. earnings have increased by 99%, 69%, and 165% for the S&P500, the DJI, and Nasdaq, respectively.

The underperformance of EM earnings since 2012 can be attributed to various factors. First, EM started the period at a level of high unsustainable earnings, buttressed by high commodity prices and a weak dollar. The strong dollar since 2012 alone accounts for 30% of the underperformance. Second, EM had a lower weight in technology stocks, and this sector in EM was hit hard by the Chinese Communist Party’s crackdown on China’s tech sector in 2020. Third, and most importantly, U.S. companies benefited from extraordinary monetary and fiscal expansion over this period, boosting revenues and reducing financial costs.

The extraordinary performance of the dominant U.S. tech stocks and their growing weight in the indices has been the main story driving markets. The great commercialization and financialization of the Information and Communications Technology (ICT) cycle has resulted in a few firms each dominating their niche and very successfully diffusing and monetizing digital technologies not only in the U.S. but worldwide.

Future performance will be determined by how the trends outlined above develop from now on:

  1. Will the current strong dollar cycle revert?
  2. Will the U.S. tech sector lose dynamism because of product maturation, regulation, or other reasons?
  3. Can the extraordinary monetary and fiscal largess be sustained in an era of rising inflation and soaring deficits?

 

3Q 2023 Expected Returns for Emerging Market Stocks

Emerging market stocks are once again proving to be disappointing in 2023 due to increasing risk aversion. Geopolitical and domestic political factors, along with a strengthening dollar, are causing investors to seek the safety of U.S. blue-chip stocks and cash. Rising interest rates, concerns about a global recession, and weak earnings in many countries are all contributing to bleak short-term prospects. Investors can only find comfort in the expectation of longer-term returns.

The chart below illustrates the current expected returns for EM markets and the S&P500, based on a CAPE ratio analysis. The Cyclically Adjusted Price-Earnings Ratio (CAPE) is calculated using the average of inflation-adjusted earnings for the past ten years, which helps to smooth out earnings’ cyclicality. This tool is particularly useful for highly cyclical assets like EM stocks and has a long history of use among investors, gaining popularity through Professor Robert Shiller at Yale University. We employ dollarized data to capture currency trends. The seven-year expected returns are calculated assuming that each country’s CAPE ratio will revert to its historical average over the period. Earnings are adjusted according to each country’s current position in the business cycle and are assumed to grow in line with nominal GDP projections from the IMF’s World Economic Outlook (IMF WEO, October 2023).

As expected, countries with “cheap” CAPE ratios below their historical average tend to have higher expected returns than those considered “expensive” with CAPE ratios above their historical average. These expected returns are based on two significant assumptions: first, that the current level of CAPE relative to the historical level is not justified; second, that market forces will correct the current discrepancy.

Historical data strongly supports the second assumption when considering seven-to-ten-year periods but not in the short term (one to three years).

Nevertheless, during certain periods when “cheap” markets on a CAPE basis exhibit short-term outperformance, investors should take note, as the combination of value and momentum can be compelling. As shown in the chart below, we are currently in such a period. Over the past twelve months, holding the “cheapest markets” has generated alpha in an EM portfolio. Although Turkey is no longer “cheap,” it was clearly so a year ago and continues to enjoy that momentum. Nearly all the better performers are inexpensive markets. The one exception is India, which, despite very high valuations, continues to attract flows from investors enamored with EM’s “last growth story.” Chile is also an obvious anomaly, as it should be delivering better returns. It is very cheap relative to its history and, being the world’s leading copper producer, offers an excellent hedge against inflation.

The fact that cheap markets are now performing well is encouraging for EM investors. However, rising geopolitical tension and slow growth do not create a conducive investment environment. As always, a strengthening dollar signals the need to stay invested in dollar-denominated quality assets.

 

 

Emerging Markets Have An Earnings Problem

The past decade has been a disaster for investors in emerging markets because nominal earnings measured in dollars have not grown.

There are several reasons for this earnings stall:

First, the past 11 years have been a period of dollar appreciation. Due to its broad global use in invoicing and financing commercial flows, a strengthening dollar has had a depressing impact on most developing countries. Moreover, as typically occurs, a strong dollar has meant weak commodity prices and poor results for commodity producers (Latin America, Russia, South Africa, etc.).

Second, the fall in earnings and investor returns can be seen as a bearish cyclical adjustment after the prior decade of plenty. The weak dollar and commodity boom of the 2002-2012 decade provided outsized results for emerging markets, which were given back over the next ten years.

Third, profitless China has weighed down the asset class. China’s capital-intensive state-run economy has resulted in very low returns on capital and persistent dilution of investors in the stock market. This was a minor issue in 2000 when China was only a small part of the EM stock indices but became a huge burden over the past decade when Chinese stocks came to dominate the indices. The brief tech boom in China (e.g., Alibaba, Tencent, massive foreign private equity inflows) changed the perceptions of investors until it was crashed by Xi’s crackdown on the companies for their “socially destructive” behavior.

The following charts illustrate the evolution of nominal dollarized earnings over time for emerging market stocks. The first chart shows earnings data for the primary EM countries and the S&P 500 during the modern era heralded by the introduction of the MSCI EM index in 1986, including estimates for 2024. Over this long period, Mexico leads by a considerable margin, while India and Taiwan are neck-and-neck with the S&P 500. Before the S&P 500’s recent spurt (2020-2023), earnings growth in EM was broadly in line with the S&P 500.

The next chart shows earnings data starting in 1992 when China was included in the MSCI EM Index. Remarkably, China’s earnings in 2023 are below the level of 1992. Brazil leads the pack over this period, with the characteristic extreme cyclicality of commodity dependence, surging during the commodity supercycle (2002-2012), tanking during the commodity collapse (2012-2016), and recovering with the bounce in commodity prices starting in 2016. India stands out as the star performer over this period, as it has provided high earnings growth without the volatility of commodity producers. Also, unlike the capital-intensive, export-oriented businesses of China, Korea, and Taiwan, India’s mogul-controlled corporates enjoy strong market power, allowing for high and consistent returns. The S&P 500 experienced enormous volatility over this period marked by the combination of financialization of the Information and Communications Technology (ICT) cycle and monetary adventurism: two bubbles (tech, 1999-2001; real estate, 2003-2007), followed by crashes; an increasingly activist Federal Reserve, resulting in 15 years of negative real interest rates. Nevertheless, the enormously profitable tech giants supported the S&P 500.

The last chart shows the period after the Great Financial Crisis (GFC), 2010-2024. The post-GFC is characterized by “secular stagnation,” a period of low growth and low inflation which was met by the Federal Reserve with policies last seen in the Great Depression of the 1930s: massive money printing, negative interest rates (financial repression), and increasingly large interventions to support asset prices. This period also saw a persistent appreciation of the USD. The clear leader over this period has been the S&P 500, propelled not only by the rising USD but also by the remarkable expansion of profit margins for the monopolistic tech giants (FAANG) which saw profit margins rise from around 10% to the current 25%. Since 2019, earnings in both Taiwan and Mexico have recovered because of stellar results from TSMC in the former and a strengthening of the peso in the latter. Weighed down by China, EM nominal earnings have fallen over this long period. These years have been equally bad for commodity producers (low prices) and East Asian exporters (rising operating and financing costs and brutal competition from China). Even India, with its high GDP growth and booming asset prices, has seen no earnings growth over this period.