Following a strong 2017, emerging market (EM) assets pulled back in 2018 as risk sentiment deteriorated amid headwinds from moderating global growth, domestic political risk and trade tensions. We believe investor concerns and repricing are overdone in light of the solid long-term fundamentals and more attractive valuations relative to developed market (DM) assets (see “A Better Deal: 2019 Annual Outlook”).
EM is too Important to Ignore
The EM landscape has seen an extraordinary transformation over the past few decades, creating a more attractive and diverse investment opportunity set. EM economies accounted for 57% of the global economy in 2017, up from 36% in 1981 when the term “emerging markets” was first coined.1 EM has also experienced a robust improvement in macro fundamentals, which should in turn drive the widening growth differential relative to DM economies. In addition, the ongoing development of EM financial markets has created a deep, liquid and diversified opportunity set. Almost half of the EM Universe was a represented by countries with a positive dependency on commodities, but that number has fallen to less than one-third today.2 As a result of this evolution across EM economies, we believe many investors need to modernize their view on EM and close their structural under-exposure to the asset class . In our view, investors should include EM in their strategic investment allocation, given the potential diversification benefits and EM’s long-term growth premium relative to DM. We estimate that the average investor allocation to EM assets is about 6%3, significantly below the 15% portfolio allocation we estimate is justified by the EM opportunity set, which is more consistent with the size of EM in the global economy and markets.
Trifecta of Growth, Fundamentals and Valuations Create a Compelling Entry Point
We believe the case for investing in EM is compelling in the current environment, despite the short-term volatility. Global economic re-convergence and rebounding growth outside of US should benefit EM assets, as market fears of trade tensions and contagion are likely to prove overdone. We are coming off an eight-year run of underperformance, which is attractive from a mean reversion perspective (Appendix). In addition, we think the sell-off created a more attractive entry point with more favorable valuations. Historically, EM economic outperformance relative to DM economies has been accompanied by outperformance in EM equities relative to DM equities. Indeed, supportive macro fundamentals have in turn revived EM corporate earnings growth, which remains solid at close to double-digits4 and is forecasted to outstrip that of DM and US this year (Exhibit, left). Despite the macro headwinds and downgrades, almost all of the underperformance in 2018 was driven by a decline in the valuation, while earnings were a positive contributor. We expect a continuation of the earnings recovery given the solid fundamental picture outside of specific countries, which is important as corporate earnings have been the primary driver of EM equity performance over the long term.5 Stronger macro fundamentals have also been accompanied by a significant improvement in EM debt fundamentals. During the “taper tantrum” of 2013, EM countries were running a current account deficit of more than 3.5% and a fiscal deficit of almost 4%. Since then, EM economies have made significant progress in reducing current account and fiscal deficits (Exhibit, right). The share of EM debt funded with foreign currency has also fallen sharply. As a result, we think EM economies are more resilient to external shocks, much less dependent on foreign investors and much less vulnerable to rising US interest rates.
Source: Left exhibit: IMF, GSAM. As of December 2018. Equity valuations shown for next twelve months price to earnings ratio for MSCI EM, MSCI World and S&P 500. Right exhibit: Haver Anatlycis, Goldman Sachs Global Investment Research, as of Q2 2018. The economic and market forecasts presented herein are for informational purposes as of the date of this presentation. There can be no assurance that the forecasts will be achieved.
How to Implement? Access a Smoother Solution
Investors have many options for implementing an allocation to EM. In our view, a blended approach that includes both equities and bonds may be an efficient and suitable method for investors seeking to participate in the sought-after growth captured by EM equity returns while dampening volatility by diversifying across EM debt. A balanced EM portfolio comprising of 40% equities and 60% fixed income would have outperformed the S&P 500 index in 9 out of the past 16 years, including the 2008 Global Financial Crisis and the 2009 recovery, two periods of heightened volatility (Appendix). In addition, this blended portfolio generated lower volatility than US equities over the past 16 years (Appendix).
Source: GSAM, Bloomberg, data as of 31-Dec-2018. EM Equity/Debt Blend = 40% MSCI EM Index, 20% JPM EMBI GD, 20% JPM GBI-EM GD and 20% CEMBI BD. EM bull cycle: 2003-2010; EM bear cycle: 2011-2018. Volatility as measured by standard deviation. Sharpe Ratio is calculated by taking the excess return of the fund versus the risk-free rate and dividing that result by the standard deviation of the fund over that same period. A drawdown is the maximum peak-to-trough decline between high-water marks (the highest peak in value that an investment reaches). Period of EM bull cycle: 2003 – 2010. Period of EM bear cycle: 2011 – 2018. Past performance does not guarantee future results, which may vary.
Source: GSAM, as of December 31, 2018. Emerging Markets Equity = MSCI Emerging Markets (EM) Index; Emerging Markets Equity + Debt = 40% MSCI EM Index, 20% JPM EMBI GD, 20% JPM GBI-EM GD and 20% CEMBI BD. All data represents total return.