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Is There Still a Long-Term Case for Emerging Market Equities?

September 2018
By Nanette Abuhoff Jacobson

It’s easy to lose faith in an asset class that’s been down 10% over the past six months.

 


 

It’s easy to lose faith in an asset class that has been down 10% over the past six months. That’s the case with emerging-market (EM) equities, which have been buffeted by a strengthening US dollar, global trade tensions, weaker growth in China, and tightening financial conditions. Collectively, these dynamics have contributed to the 10% drawdown and $4 billion of outflows from exchange-traded funds (ETF) and mutual funds.1

While these challenging cyclical factors are likely to persist over the next six to 12 months, I see compelling structural reasons to consider maintaining an allocation to emerging-market equities over the long term, and even considering increasing an allocation, should already-low valuations fall further.

EMs have a demographic profile that is more supportive of growth than developed markets. FIGURE 1 shows that the working-age population in EMs is expected to increase by 50% over the next 80 years, from four billion to six billion workers. Over that same period, the developed market working-age population is expected to shrink by 15%, from 820 million to 710 million. Given that EMs already contribute 40% to global gross domestic product (GDP)2 (up from 28% 10 years ago), the expanding working-age population could be a meaningful indicator of future growth.3

Figure 1: More workers point to stronger growth in EMs over the long run

Sources: United Nations, Haver Analytics

Apart from demographics, several additional dynamics support the long-term case for EMs:

- Improved fundamentals — While a handful of countries have poor fundamentals, most EM countries’ situations have improved in recent years, with higher currency reserves, lower current account deficits, and lower inflation.

- Attractive valuations — EM’s Shiller price-to-earnings ratios (P/Es),4 a long-term valuation metric, are in the bottom quartile relative to the past 10-year period; Shiller P/Es for the US and Europe, meanwhile, are in the top decile.

- Increasing share of the global market — As EM economies contribute more to global GDP, they will also comprise a larger share of global equity indexes. For example, EMs have grown to comprise 11% of the MSCI All Country World Index,5 up from 3.5%
20 years ago. Investors who lack EM exposure will be making an active decision not to benefit from the drivers of global growth.

- Rise of consumerism — EMs are transitioning from industrial economies to more consumer-oriented economies. As the middle class continues to grow, sectors, such as healthcare, education, travel, financial services, and technology may have significant upside.

Investment Implications 

I believe the long-term case for EMs holds — Although short-term headwinds could make for a bumpy ride, the long-term case is intact. In my view, sharp sell-offs in EM equities could present investment opportunities.

Consider targeted exposure — Active approaches can help expose investors to consumer-oriented sectors, as well as export-oriented sectors, that tend to benefit from a cheaper local currency relative to the US dollar.

Consider US-dollar-denominated debt — In light of EM equities’ near-term volatility, US-dollar-denominated debt could be a lower-risk way to gain EM exposure in the interim.

Some risks remain — An escalation of trade tensions or the erosion of orthodox policymaking would represent longer-term negatives for EM.

Managing Director and Multi-Asset Strategist at Wellington Management Company LLP and Global Investment Strategist for Hartford Funds.

1 Monthly and weekly data in August from EPFR
2 Gross Domestic Product (GDP) is the monetary value of all the finished goods and services produced within a country’s borders in a specific time period.
3 United Nations, Haver Analytics
4  Shiller price-to-earnings is a valuation measure, generally applied to broad equity indices, that uses real per-share earnings over a 10-year period. A lower valuation indicates that stocks are cheaper than they have been historically and vice versa.
5  MSCI All Country World Index is a free float-adjusted market capitalization index that measures equity market performance in the global developed and emerging markets, consisting of developed and emerging market country indices. MSCI index performance is shown net of dividend withholding tax. This Index is unmanaged and not available for direct investment.

 

Important Risks: Investing involves risk, including the possible loss of principal. • Foreign investments may be more volatile and less liquid than U.S. investments and are subject to the risk of currency fluctuations and adverse political and economic developments. These risks may be greater for investments in emerging markets. • Focusing on investments in particular sectors may increase its volatility and risk of loss if adverse developments occur.

The views expressed here are those of Nanette Abuhoff Jacobson. They should not be construed as investment advice. They are based on available information and are subject to change without notice. Portfolio positioning is at the discretion of the individual portfolio management teams; individual portfolio management teams and different fund sub-advisers may hold different views and may make different investment decisions for different clients or portfolios. This material and/or its contents are current as of the time of writing and may not be reproduced or distributed in whole or in part, for any purpose, without the express written consent of Wellington Management or Hartford Funds.

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