The correlation between U.S. and Emerging Markets (EM) tech sector returns has been rising strongly for three years. As a result, imbalances in EM market returns have reached extreme levels. Broken down by sector, tech has contributed around 40% of EM returns over the past three years, a share matched only by energy in 2007.1 In the past, when the country and sector leaders in MSCI EM accounted for anywhere close to this large a share of returns, it signaled a return to a more normal balance—and a change in leaders.
The infatuation with big tech stocks has driven the relative performance of small and medium caps (on an equal weighted index) to nearly two standard deviations below its historical trend in the emerging markets, as shown in Display 1. This is highly unusual. EM small and medium caps have never fallen this far in the 20-year history of the equal weighted index and came close only once, during the rage for large U.S. tech stocks in 2000. In the United States, by the same measure, the relative performance of small and medium caps has fallen by two standard deviations only three times in the last 100 years, during the Great Depression, the Nifty Fifty Bubble of the 1970s and the tech bubble of the late 1990s.2 In all these past cases, small and medium caps started to outperform when mega caps began to falter, or even before.
Our argument, for some time, has been that when market imbalances grow this extreme, they don’t persist, as a rule. Now that we have begun to see major falls in tech and the tech-heavy MSCI China index, the question is how the rebalancing is likely to play out. After the busts of 2000 and 2008, beaten-down sectors recovered, small and medium caps came back to life, and forgotten countries were rediscovered.
Over the past few years, investors became so focused on the tech-heavy Asian markets, they appeared to ignore the fundamentals of economic growth. Beginning with the launch of the MSCI EM index in 1988, the best returns had come in the fastest growing economies. But after 2016, economies with the highest growth rates underperformed the MSCI EM index, and those with the lowest growth rates outperformed. Many of the outperformers were tech-heavy.
Even after the recent declines, markets are still valuing big tech companies more highly than entire clusters of major emerging economies. After becoming the first $1 trillion company, Apple is down under $900 billion, but still in the same range as Indonesia and Malaysia combined, and nearly three times more than Poland.3 The last time we saw companies overshadow countries this way was in Asia after the crisis of 1998, when for example, GE was valued more highly than the crisis-hit economies of Russia, Malaysia and South Korea combined. The big difference this time: many of the battered countries face no crisis and are growing rapidly.
Now, some of them are starting to come back. As investors sell out of tech, they are rediscovering some overlooked markets of Eastern Europe and Latin America. Those markets had been battered in part by the strong dollar, which always sucks money out of EM, but may not last this time. Since the early 1980s, the dollar has rarely traded more than 15% above or below its long-term range, and it is now at the high end of that range.4 Dollar bear markets have tended to last around seven years. Our view is that the dollar’s rise in 2018 is a temporary rally within the downtrend that began in early 2016 and could prove long-lasting.
Some of the hardest hit EM currencies have stabilized, and we see no reason to expect the broad collapse to resume. As a group, emerging markets have strong external balances. Current account deficits are low on average, having fallen significantly since the “taper tantrum” of 2013 rattled countries like Brazil and India. Though many analysts are worried about emerging market debt, this risk is a threat mainly to China. While the rest of EM has seen its nonfinancial debt climb by 20 percentage points as a share of GDP since the global financial crisis of 2008, China’s debt has grown by more than 100 percentage points.5 Tellingly, the China market too had been driven largely by tech stocks, until the recent correction.
The question, then, is how to think about emerging markets as an asset class as the mania for tech passes?
Go back to the fundamentals that have driven markets over time. Our “rules of the road” zero in on the 10 most important factors for identifying countries likely to post high or accelerating growth, and thus most likely to outperform the markets over the next three to five years. Right now, some of the most beaten down markets are in promising economies such as Poland, Indonesia, the Philippines and even Mexico.
One of our most important rules says that a cheap currency is a good sign, and this is particularly so for countries that have seen currencies plummet this year even though they face no threat of crisis. Analysts who worry about Mexico’s new leftist president, Andrés Manuel López Obrador, overlook the fact that his impact was priced into the peso even before his July election victory. By our composite measure, the Mexican peso is currently the cheapest currency in the world.6
EM stocks now look relatively cheap (based on price to book) compared to Developed Market (DM) stocks on average, and historically cheap in some cases. In dollar terms, Mexico’s market is now near a two decade low. Poland, with its beaten-down zloty is near a 25-year low. Both suffer mainly from the lack of major tech stocks in their index.
Looked at more broadly, the entire EM class was in some sense overlooked even before this year’s drawdown. As of last December, only about 4-6% of global equity investments were allocated to emerging markets, a share that is too low based on any of the three standard approaches to asset allocation. Basing investments on the EM weight in global equity markets would imply an allocation of 12%;7 using the EM share of global GDP would imply an allocation of at least 15% and using an optimal portfolio approach would suggest an allocation of 30%.8
The upshot is that we believe many emerging markets look like compelling long-term buys. Many of the beaten down countries are well-insulated from crisis and are caught in an anti-bubble—gasping in a vacuum of attention because even now investors are focused on tech and tech-heavy markets like MSCI China. As a sense of normalcy returns to markets, other sectors and countries are likely to pick up momentum. While trying to time markets is a fool’s game, the time to make long-term investments is in periods like the current one, when stock prices in many high-growth emerging markets appear to be cheap for no good reason.
1 MSIM, Bloomberg, FactSet, Haver, data as of November 28, 2018.
2 MSIM, Bloomberg, FactSet, Haver, data as of November 28, 2018.
3 FactSet, Haver, data as of November 28, 2018.
4 MSIM EME Team Research, FactSet, data as of November 28, 2018.
5 FactSet, BIS, IMF, Haver, MSIM EME Team Research, Bloomberg. Data as of November 28, 2018.
6 MSIM EME Team Research, Haver, data as of November 28, 2018.
7 FactSet. Data as of December 2017.
8 FactSet, MSCI, HSBC, MSIM Estimates. Data as of December 2017.
There is no assurance that a Portfolio will achieve its investment objective. Portfolios are subject to market risk, which is the possibility that the market values of securities owned by the Portfolio will decline and that the value of Portfolio shares may therefore be less than what you paid for them. Accordingly, you can lose money investing in this Portfolio. Please be aware that this Portfolio may be subject to certain additional risks. In general, equities securities’ values also fluctuate in response to activities specific to a company. Investments in foreign markets entail special risks such as currency, political, economic, market and liquidity risks. The risks of investing in emerging market countries are greater than risks associated with investments in foreign developed countries. Privately placed and restricted securities may be subject to resale restrictions as well as a lack of publicly available information, which will increase their illiquidity and could adversely affect the ability to value and sell them (liquidity risk). Derivative instruments may disproportionately increase losses and have a significant impact on performance. They also may be subject to counterparty, liquidity, valuation, correlation and market risks. Illiquid securities may be more difficult to sell and value than public traded securities (liquidity risk).
DEFINITIONS: Current account deficit is a measurement of a country’s trade in which the value of goods and services it imports exceeds the value of goods and services it exports. 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. It includes all private and public consumption, government outlays, investments and net exports. The MSCI Emerging Markets Index (MSCI EM) is a free float-adjusted market capitalization weighted index that is designed to measure equity market performance of emerging markets. The MSCI China Index captures large and mid-cap representation across China A-shares, B-shares, H-shares, Red-chips and P-chips. It reflects the Mainland China and Hong Kong opportunity set from an international investor’s perspective. The indexes are unmanaged and do not include any expenses, fees or sales charges. It is not possible to invest directly in an index. Price-To-Book Ratio (Price/Book) compares a stock’s market value to the book value per share of total assets less total liabilities. This number is used to judge whether a stock is undervalued or overvalued.
IMPORTANT DISCLOSURES: The views and opinions are those of the author as of the date of publication and are subject to change at any time due to market or economic conditions and may not necessarily come to pass. Furthermore, the views will not be updated or otherwise revised to reflect information that subsequently becomes available or circumstances existing, or changes occurring, after the date of publication. The views expressed do not reflect the opinions of all portfolio managers at Morgan Stanley Investment Management (MSIM) or the views of the firm as a whole, and may not be reflected in all the strategies and products that the Firm offers.
Forecasts and/or estimates provided herein are subject to change and may not actually come to pass. Information regarding expected market returns and market outlooks is based on the research, analysis and opinions of the authors. These conclusions are speculative in nature, may not come to pass and are not intended to predict the future performance of any specific MSIM product.
Certain information herein is based on data obtained from third party sources believed to be reliable. However, we have not verified this information, and we make no representations whatsoever as to its accuracy or completeness.
The information herein is a general communications which is not impartial and has been prepared solely for information and educational purposes and does not constitute an offer or a recommendation to buy or sell any particular security or to adopt any specific investment strategy. The material contained herein has not been based on a consideration of any individual client circumstances and is not investment advice, nor should it be construed in any way as tax, accounting, legal or regulatory advice. To that end, investors should seek independent legal and financial advice, including advice as to tax consequences, before making any investment decision.
Past performance is no guarantee of future results.
This communication is not a product of Morgan Stanley’s Research Department and should not be regarded as a research recommendation. The information contained herein has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on dealing ahead of the dissemination of investment research.
There is no guarantee that any investment strategy will work under all market conditions, and each investor should evaluate their ability to invest for the long-term, especially during periods of downturn in the market. Prior to investing, investors should carefully review the strategy’s / product’s relevant offering document. There are important differences in how the strategy is carried out in each of the investment vehicles.
DISTRIBUTION: This communication is only intended for and will only be distributed to persons resident in jurisdictions where such distribution or availability would not be contrary to local laws or regulations.
United Kingdom: Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority. Registered in England. Registered No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA, authorised and regulated by the Financial Conduct Authority. Dubai: Morgan Stanley Investment Management Limited (Representative Office, Unit Precinct 3-7th Floor-Unit 701 and 702, Level 7, Gate Precinct Building 3, Dubai International Financial Centre, Dubai, 506501, United Arab Emirates. Telephone: +97 (0)14 709 7158). Germany: Morgan Stanley Investment Management Limited Niederlassung Deutschland Junghofstrasse 13-15 60311 Frankfurt Deutschland (Gattung: Zweigniederlassung (FDI) gem. § 53b KWG). Italy: Morgan Stanley Investment Management Limited, Milan Branch (Sede Secondaria di Milano) is a branch of Morgan Stanley Investment Management Limited, a company registered in the UK, authorised and regulated by the Financial Conduct Authority (FCA), and whose registered office is at 25 Cabot Square, Canary Wharf, London, E14 4QA. Morgan Stanley Investment Management Limited Milan Branch (Sede Secondaria di Milano) with seat in Palazzo Serbelloni Corso Venezia, 16 20121 Milano, Italy, is registered in Italy with company number and VAT number 08829360968. The Netherlands: Morgan Stanley Investment Management, Rembrandt Tower, 11th Floor Amstelplein 1 1096HA, Netherlands. Telephone: 31 2-0462-1300. Morgan Stanley Investment Management is a branch office of Morgan Stanley Investment Management Limited. Morgan Stanley Investment Management Limited is authorised and regulated by the Financial Conduct Authority in the United Kingdom. Switzerland: Morgan Stanley & Co. International plc, London, Zurich BranchI Authorised and regulated by the Eidgenössische Finanzmarktaufsicht (“FINMA”). Registered with the Register of Commerce Zurich CHE-115.415.770. Registered Office: Beethovenstrasse 33, 8002 Zurich, Switzerland, Telephone +41 (0) 44 588 1000. Facsimile Fax: +41(0)44 588 1074.
U.S.: A separately managed account may not be suitable for all investors. Separate accounts managed according to the Strategy include a number of securities and will not necessarily track the performance of any index. Please consider the investment objectives, risks and fees of the Strategy carefully before investing. A minimum asset level is required. For important information about the investment manager, please refer to Form ADV Part 2.
Please consider the investment objectives, risks, charges and expenses of the funds carefully before investing. The prospectuses contain this and other information about the funds. To obtain a prospectus please download one at morganstanley.com/im or call 1-800-548-7786. Please read the prospectus carefully before investing.
Morgan Stanley Distribution, Inc. serves as the distributor for Morgan Stanley Funds.
NOT FDIC INSURED | OFFER NO BANK GUARANTEE | MAY LOSE VALUE | NOT INSURED BY ANY FEDERAL GOVERNMENT AGENCY | NOT A BANK DEPOSIT
Hong Kong: This document has been issued by Morgan Stanley Asia Limited for use in Hong Kong and shall only be made available to “professional investors” as defined under the Securities and Futures Ordinance of Hong Kong (Cap 571). The contents of this document have not been reviewed nor approved by any regulatory authority including the Securities and Futures Commission in Hong Kong. Accordingly, save where an exemption is available under the relevant law, this document shall not be issued, circulated, distributed, directed at, or made available to, the public in Hong Kong. Singapore: This document should not be considered to be the subject of an invitation for subscription or purchase, whether directly or indirectly, to the public or any member of the public in Singapore other than (i) to an institutional investor under section 304 of the Securities and Futures Act, Chapter 289 of Singapore (“SFA”), (ii) to a “relevant person” (which includes an accredited investor) pursuant to section 305 of the SFA, and such distribution is in accordance with the conditions specified in section 305 of the SFA; or (iii) otherwise pursuant to, and in accordance with the conditions of, any other applicable provision of the SFA. Australia: This publication is disseminated in Australia by Morgan Stanley Investment Management (Australia) Pty Limited ACN: 122040037, AFSL No. 314182, which accept responsibility for its contents. This publication, and any access to it, is intended only for “wholesale clients” within the meaning of the Australian Corporations Act.
Japan: For professional investors, this document is circulated or distributed for informational purposes only. For those who are not professional investors, this document is provided in relation to Morgan Stanley Investment Management (Japan) Co., Ltd. (“MSIMJ”)’s business with respect to discretionary investment management agreements (“IMA”) and investment advisory agreements (“IAA”). This is not for the purpose of a recommendation or solicitation of transactions or offers any particular financial instruments. Under an IMA, with respect to management of assets of a client, the client prescribes basic management policies in advance and commissions MSIMJ to make all investment decisions based on an analysis of the value, etc. of the securities, and MSIMJ accepts such commission. The client shall delegate to MSIMJ the authorities necessary for making investment. MSIMJ exercises the delegated authorities based on investment decisions of MSIMJ, and the client shall not make individual instructions. All investment profits and losses belong to the clients; principal is not guaranteed. Please consider the investment objectives and nature of risks before investing. As an investment advisory fee for an IAA or an IMA, the amount of assets subject to the contract multiplied by a certain rate (the upper limit is 2.16% per annum (including tax)) shall be incurred in proportion to the contract period. For some strategies, a contingency fee may be incurred in addition to the fee mentioned above. Indirect charges also may be incurred, such as brokerage commissions for incorporated securities. Since these charges and expenses are different depending on a contract and other factors, MSIMJ cannot present the rates, upper limits, etc. in advance. All clients should read the Documents Provided Prior to the Conclusion of a Contract carefully before executing an agreement. This document is disseminated in Japan by MSIMJ, Registered No. 410 (Director of Kanto Local Finance Bureau (Financial Instruments Firms)), Membership: The Investment Trusts Association, Japan, the Japan Investment Advisers Association and the Type II Financial Instruments Firms Association.
IMPORTANT INFORMATION: EMEA: This marketing communication has been issued by Morgan Stanley Investment Management Limited (“MSIM”). Authorised and regulated by the Financial Conduct Authority. Registered in England No. 1981121. Registered Office: 25 Cabot Square, Canary Wharf, London E14 4QA.
Any index referred to herein is the intellectual property (including registered trademarks) of the applicable licensor. Any product based on an index is in no way sponsored, endorsed, sold or promoted by the applicable licensor and it shall not have any liability with respect thereto.
Charts and graphs provided herein are for illustrative purposes only.
The information contained in this communication is not a research recommendation or ‘investment research’ and is classified as a ‘Marketing Communication’ in accordance with the applicable European regulation or Swiss regulation. This means that this marketing communication (a) has not been prepared in accordance with legal requirements designed to promote the independence of investment research (b) is not subject to any prohibition on dealing ahead of the dissemination of investment research.
MSIM has not authorised financial intermediaries to use and to distribute this document, unless such use and distribution is made in accordance with applicable law and regulation. MSIM shall not be liable for, and accepts no liability for, the use or misuse of this document by any such financial intermediary. If you are a distributor of the Morgan Stanley Investment Funds, some or all of the funds or shares in individual funds may be available for distribution. Please refer to your sub-distribution agreement for these details before forwarding fund information to your clients.
The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without MSIM’s express written consent.
All information contained herein is proprietary and is protected under copyright law.
Morgan Stanley Investment Management is the asset management division of Morgan Stanley.
This document may be translated into other languages. Where such a translation is made this English version remains definitive. If there are any discrepancies between the English version and any version of this document in another language, the English version shall prevail.
CRC 2346065 Exp: 12/31/2019