Morgan Stanley
  • Wealth Management
  • Jan 25, 2021

5 Reasons Why Emerging Markets May Just Be Getting Started

China’s post-pandemic strength, plus currency dynamics and attractive valuations, could drive more emerging-market gains, especially in Asia.

Since Nov 1, the S&P 500 Index has risen 17%, propelled to new highs by a positive outlook stemming from vaccine approvals, additional economic stimulus and the Democrat Party winning control of both Congress and the White House. 

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Yet, emerging markets are up even more, with the MSCI Emerging Markets Index gaining 26% in that time. Here are five main reasons why we expect that outperformance to continue:

  • China’s post-pandemic economic recovery will likely fuel global growth in emerging markets, especially in Asia. While most developed markets, including the U.S., hope to exit recession by the end of the second quarter, China ended 2020 with economic growth of 2.3%. Even more significant, government stimulus wasn’t a major driver of this growth, giving policymakers more room to act if the economy stalls. Equally important, its exports to the U.S. have rebounded to 2018 levels, as of December—evidence of having weathered the hit from U.S. tariffs and trade tensions in 2018-19. Moreover, its share of total global exports climbed to 14.3% last year, an all-time high. 
  • Demand from China’s consumers is increasingly important for corporate profits globally. The growing middle class should drive continued global economic growth, especially in other emerging markets in Asia. Morgan Stanley & Co.’s economics team is forecasting 2021 China GDP growth of 9% and overall emerging market growth of 7.4%. Potential sales growth for emerging markets companies suggests profits could soar 30%-35%.
  • Currency dynamics could benefit emerging markets. Since commodities produced in emerging markets are often priced in U.S. dollars, we expect continued U.S. dollar weakness and strong commodity prices to help keep many emerging market stocks buoyant. Plus, emerging market inflation is low while many countries’ finances are healthy, supporting continuing positive indicators around global currency dynamics.
  • Emerging-market valuations are relatively attractive, based on yields and earnings. Looking first at bonds, in a world where $17 trillion of developed-market sovereign debt effectively offer negative yields, emerging-market fixed-income securities remain a bastion of positive real yields. On the equity side, current price-to-earnings ratios, at 16.2 times forward earnings estimates, offer comparative bargains against the S&P 500’s current forward ratio of nearly 23 times.
  • The equity risk premium points to more upside. The equity risk premium measures the excess return an investor stands to gain compared to a low-risk investment. Using the 10-year U.S. Treasury as a so-called risk-free rate, emerging-market stocks currently offer a nine-percentage-point premium, or about three times that of the S&P 500. This compares to prior periods of peak emerging-market relative performance, when the equity risk premium fell to between two and four percentage points, suggesting that, for emerging-market stocks, the cycle may have just begun.

To be sure, emerging-market gains may slow as vaccine rollouts hit short-term bumps, but we see bigger forces at work supporting relative outperformance over the next several years. Investors should consider redeploying any gains in the long outperforming U.S. market toward actively managed emerging markets funds, with an emphasis on Asia.

This article is based on Lisa Shalett’s Global Investment Committee Weekly report from Jan 25, 2020, “Emerging Markets Just Get Going.” Ask your Financial Advisor for a copy or find an advisor. Listen to the audiocast based on this report.

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