Read what we are discussing this week:
- Emerging market (EM) stocks are up nearly 34% so far this year. Stocks globally have risen sharply in 2017 likely leaving many investors wondering how much upside, if any, might be left.
- Emerging markets have come through a pretty dismal period. Earnings for the MSCI EM Index went from $111 in 2011 to $67 in 2016. There were multiple headwinds: growth had slowed (China), many of these economies were carrying a heavy debt load (Brazil), and then the US dollar strengthened, which hurts EM earnings translated into dollars.
- Now, earnings in the emerging markets are growing again, estimated to be $88 next year. The dollar has stabilized/fallen, economic growth broadly across the EM is accelerating with the largest EM economy, China, notably recovering.
- Strong performance by US stocks in recent years has probably left many investors indifferent at best to having EM exposure in their portfolios. Over a long period of time, however, EM has outperformed US stocks, notching an 11% annualized total return since 1988 versus 10% for the S&P 500.
- Valuations on emerging market stocks are still attractive with the MSCI EM Index trading at less than 13x earnings even after such a big move up. The ten-year average multiple is 11.2x, and it appears we are still early in the recovery. If history is any guide, emerging market cycles can last several years.
- Importantly, the makeup of earnings in the emerging markets has changed. Whereas, six years ago energy and materials made up 30% of the index, today these sectors comprise about 14%. Meanwhile, technology has gone from 12% to 26%. That is, today’s leadership is less cyclical and less driven by commodity prices than in the past.
- The case for a long-term allocation to emerging markets: these economies have about 84% of the world’s population, are expected to generate nearly half of global GDP, but represent less than 20% of global stock market capitalization.
- This year has been notable for its lack of volatility. The S&P 500 has been up every month through October and the largest draw down this year has been a modest 3%.
- Volatility has been absent from emerging markets as well, but investors should be aware that 10% drawdowns are typical in EM even during periods of strength.
- At Heritage, our EM exposure is through managers that have a conservative approach, focusing on less export, cyclically-oriented companies with good balance sheets.
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