From 2017 to earlier this year, Emerging Market (EM) equities had been bolstered by the consensus optimism on a strong and synchronized global growth. However, this did not materialize – instead, economic growth moderated in many developed and emerging market economies outside of exceptionalism in US, hurting investor sentiment on EM along with other risk assets. In addition, elections across both developed (Italy and Spain) and emerging markets (Russia, Turkey, Indonesia and upcoming in Brazil) have created uncertainty around political outcomes, we believe thus sparking bouts of market volatility and weighing on EM equities. Compounding this has been the escalating geopolitical uncertainty and macro implications of further US tariffs on Chinese exports. In our opinion, the EM sell-off was further exacerbated by country-specific weaknesses such as US sanctions on Russia, as well as external funding concerns for Turkey and Argentina.
We believe these country-specific drivers warrant only isolated weaknesses rather than the broad-based sell-off we have recently seen, as EM remains a heterogeneous asset class. The fundamental impact of trade and idiosyncratic risks to broader EM growth and equities should be limited in our opinion, although we are alert to second-round impacts on investments and business confidence, as well as short-term contagions from negative sentiment. For example, Turkey comprises only 5% of EM GDP on a trade-weighted basis1, and 0.6% of the MSCI index2. Argentina is only 1% of EM trade-weighted GDP1, and is currently classified as a frontier market and is expected to have weight of 0.4% upon its inclusion in the MSCI EM index in August 2019. In addition, EM remains a largely domestic-facing universe, where many countries are somewhat insulated from escalating trade tensions and EM companies in aggregate only derive 8% of their total revenue from the US2. China remains a large component of the EM economy and equity market (50% of trade-weighted EM GDP1 and 31% of MSCI EM2), but the direct economic impact of the latest US tariffs to China’s $13 trillion GDP would be approximately only 0.5% even if export volumes fell by twice the amount of the 25% tariff3, and we expect supportive domestic policy to somewhat offset the risks from trade.
Macro imbalances have improved in several EM economies since the 2013 Taper Tantrum, and fundamentals are also healthier. While the recent outperformance of US growth coupled with an economic moderation in EM and other global economies has pressured EM assets, we expect a shift to economic convergence as US growth eases with fading fiscal support while other economies stabilize. As we discuss in GSAM Outlook: EM Comeback, EM assets will potentially be the largest beneficiary from such an economic convergence, as market fears of trade tensions and EM contagion are likely to prove overdone. And we remain confident that the longer-term picture – whereby EM will account for close to 75% of global growth over the coming decade and in the process lift close to 1.2 billion people out of poverty and into the middle income class – can continue to support differentiated, domestic-facing businesses. We continue to expect an improvement in the EM versus DM growth premium over the medium term – an environment that has historically correlated to EM equity outperformance. The robust macro background should in turn drive earnings, which is expected to grow at a robust 12%4 over the next 12 months and reflect a healthy outlook, despite recent downgrades amid headwinds. This is important, as corporate earnings have historically been the predominant driver of EM equity performance over the long term, significantly eclipsing dividends, valuation and currency effects (Exhibit).
Source: Goldman Sachs Global Investment Research, calculated using monthly MSCI EM index data from October 1995 to September 2017.
While we acknowledge the potential for continued near-term EM volatility, we believe that structural tailwinds for EM remain intact over the medium to long term – more robust economic fundamentals, strong economic growth, favorable demographic trends and healthy corporate earnings growth. Meanwhile, valuations suggest the negative market sentiment is overdone. With the recent sell-off, 12 month forward price-to-earnings for EM equities are back below their long-term average and trading at the largest discount to US equities in 14 years5, offering an interesting entry-point to a multi-year recovery story. Finally, as bottom-up investors, we prefer to avoid exposure to binary geopolitical and political outcomes. We remain selective and focused on finding companies that have the potential to span beyond the benchmark in order to take advantage of our 30-person locally based EM Equity investment team.