Emerging market stocks have persistently underperformed the S&P 500 for the past decade, leading to renewed faith in American exceptionalism and consistent international flows into the perceived soundness and reliability of U.S. assets. Nevertheless, if we look at the data, we can conclude that there are good reasons for the run in U.S. stocks but also evidence to believe it will not last for ever.
The performance of EM stocks relative to the S&P 500 can be seen as a tale of two decades. As the chart below shows, EM stocks dominated for the first ten years while the S&P 500 won handily in the second decade, through June 2023.
Most of this performance can be explained by changes in valuation as measured by price-earnings and CAPE ratios (CAPE, cyclically adjusted PE), as shown below. U.S. ratios started high in 2002 and fell during the next decade and then rebounded in the 2012-2023 period. The exact opposite occurred for EM: ratios were at very low levels in 2012, rose during the decade and now have fallen back to low levels.
The chart below digs deeper to further explain the disparate performances of EM and S&P 500 stocks over the past two decades, by showing annualized earnings growth and currency effects for both assets. The chart breaks down annualized index performance for both decades in terms of earnings and PE multiple expansion, and also provides the contribution from currency exchange rate movements for emerging markets. The S&P suffered from significant multiple contraction in the first decade and benefited from a large multiple expansion in the second decade. EM benefitted from strong earnings growth boosted by currency appreciation in the first decade and suffered from negative earnings growth pushed down by currency depreciation in the second decade. CAPE ratio for the S&P 500 fell slightly between 2002 and 2012 and then expanded massively in the second decade, while CAPE ratios for EM rose sharply between 2002 and 2012 and then collapsed from 2012 to 2023.
The drivers of S&P relative performance over the past decade have been primarily multiple expansion and dollar appreciations, two factors that have proven to be cyclical in the past and highly prone to reversion.
We can also point to other extraordinary events that have provided a one- time boost to the S&P 500 index. Recent work from Michael Smolyansky at the Federal Reserve ((link) and Minje Kwun at Verdad Capital (link) highlight the importance that reductions in corporate taxes and low interest rates have had in driving earnings growth over the past decade. The chart below shows the remarkably favorable circumstances that American corporations have had since the late 1980s, and the sharp fall in interest rates and taxes over the 2012-2022 period. The recent rise in interest rates and the prospect of rising U.S. debt and fiscal deficits point to a cyclical reversion of these trends in the coming decade.
None of the factors boosting U.S. stocks have benefitted emerging market stocks over the past ten years, which may leave EM stocks better positioned to outperform.