After several years of disappointing returns, emerging-market (EM) equities are regaining interest, attracting flows and outperforming their developed-market (DM) counterparts this year. For investors thinking about adding EM exposure, we offer seven factors to consider.
1. Earnings growth, finally. Over time, stock returns are driven by earnings growth. At the index level, EM stocks didn’t deliver any earnings growth from 2010 to 2013, so it should come as no surprise that they lagged. This year, however, companies are expected to grow EPS by 9%, followed by 12% growth in 2015, providing a stronger foundation for stock prices.
2. Monitor global events, but don’t become paralyzed. In a year that included Russia’s invasion of Ukraine, renewed unrest in the Middle East, China’s slowing economy, the tapering of the US Federal Reserve’s bond buying, a drought in Brazil and elections in India and Indonesia, EM equities have delivered a respectable 15% return. The lesson: it pays to stay disciplined in the face of headline risks.
3. The easy EM beta trade is likely behind us. Over the past decade, passive exposure to EM stocks outperformed passive exposure to DM stocks by about 3% annualized, propelled by EM’s more rapid relative economic growth, a big profitability and earnings growth advantage and a starting point of depressed stock valuations. Those advantages are more muted today, so the return potential from passive exposure to EM stocks is also likely to be more muted in the years ahead.
4. Volatility is a bigger hurdle. With EM index returns likely facing greater headwinds in the years ahead, we believe that allocations to EM equities will have to work harder to compensate for their far greater volatility. In our view, that means finding ways to generate meaningfully higher returns than the index and/or employing strategies to reduce volatility. In either case, the bar is higher for passive index-tracking approaches than it is for active strategies, which have more room to maneuver.
5. Good news: alpha potential remains high. The flow of information about countries and companies is slower and less transparent in developing markets, creating mispricings that resourceful stock pickers can exploit. Well-established factors such as valuation, profitability and price momentum continue to be more productive in driving excess returns in EM than in DM, particularly when combined, as we show in the Display, below. Disciplined approaches that target historically reliable return drivers should continue to be rewarded.
6. Prepare for the end of the “safety trade.” Amid decelerating EM economic growth and lingering postcrisis uncertainties, investors have been paying bigger and bigger premiums for EM companies with strong current performance, while shunning companies whose earnings growth may come further into the future. The valuation spread between the two has reached an extreme only seen in about 5% of periods over the past 20 years. These junctures have tended to be the most productive times to rebalance to value-investing strategies, even at the expense of some quality. Index trackers risk being overly concentrated in yesterday’s pricier winners.
7. Diversify your exposure with multi-asset strategies and smaller markets. There are also ways to tap EM return potential while diversifying risk. For example, multi-asset strategies can generate equitylike returns with less volatility by broadening the investment opportunity set to encompass select EM bonds. Investors should also consider adding exposure to smaller developing-world markets, many of which are growing quickly, yet remain less correlated than the BRICs and are often riper for stock-picking because of greater information inefficiencies. Ten years from now, we expect markets such as Vietnam, Nigeria, Colombia and Qatar to become more significant constituents in global portfolios.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.
Morgan C. Harting is an Emerging Markets Portfolio Manager at AllianceBernstein (NYSE:AB).