While the pandemic stalled global consumption, the slowdown isn’t expected to be a permanent impairment for emerging markets. Read more from Raymond James Senior Investment Strategist Tracey Manzi, CFA.
To read the full article, see the Investment Strategy Quarterly publication linked below.
The global economy has recovered strongly from the pandemic; however, growth has been uneven. Advanced economies have been in the driver’s seat throughout the recovery, as access to vaccines and acceptance rates have accelerated the reopening process in their respective economies. Emerging markets have faced considerable challenges as the lingering virus and slower than anticipated vaccine rollouts have created headwinds for their recoveries.
These diverging paths have led to a narrowing in the growth premium between developed and emerging markets and caused the performance of emerging market equities to fall further behind their developed peers. While the recent setback is disappointing, we still believe that emerging markets offer strong long-term potential and diversification benefits in a balanced portfolio.
Emerging markets have been a dominate force in the global economy over the last twenty years. In 2001, emerging markets accounted for over 40% of global growth. Today, they represent nearly 58% of the global economy. The International Monetary Fund expects their share to rise to over 60% by 2025 as the urbanization of their economies and growth of the middle class continues. While pandemic-related challenges are temporarily restraining growth relative to developed markets, we do not expect this trend to continue. With vaccination rates improving and tentative signs that COVID cases are stabilizing, the near-term weakness in emerging market growth may not be as soft as the market fears. This should tilt the growth differential back in favor of emerging markets, with another meaningful boost when the impact of the sizeable fiscal and monetary stimulus in developed markets starts to fade.
The recent weakness in emerging market equities has widened the valuation gap with developed markets even further from already discounted levels. The underperformance of the asset class has caused the MSCI Emerging Markets Index to trade at a 30-35% discount relative to the MSCI World Index and a 40% discount to the S&P 500 Index. This is significantly below historical averages. While much of the discount is attributable to the valuation premium associated with US stocks, emerging market equities are nearing their cheapest levels in over twenty years. These attractive valuation levels will surely appeal to valuation-conscious investors.
The rapid ascent of the middle class has been one of the key drivers behind the explosive growth in emerging markets over the last two decades. While the pandemic may have stalled consumption growth across the globe, we do not believe that the slowdown will turn into a permanent impairment in emerging markets. With the size of the global middle class expected to rise considerably over the next decade, and the bulk of the gains coming from the Asia Pacific region, we believe the slowdown will be short-lived. Once the pandemic-related challenges start to level off, the rising middle class should support increasing consumption and underpin growth trends for years to come.
Over the last decade, emerging markets have transformed from cyclically-oriented, commodity-based markets to high-powered technology leaders. While cyclical factors continue to play a role, the Technology sector has emerged as one of the most important drivers within emerging market growth. While China was at the forefront of this revolution, a growing list of tech-related companies within the emerging market universe are trying to capitalize on the growing markets for e-commerce, mobile banking, artificial intelligence, health care, electric-vehicle batteries, and more. We expect these trends to continue as more companies look to meet the needs of their tech-savvy consumers.
We continue to believe that emerging markets will remain a powerful driver of global growth and the recent narrowing in its growth premium should be short-lived. The longer-term benefits of investing in economies with superior growth prospects and supportive demographic and consumer trends should lift valuations relative to its developed market peers. While the coming months may bring some additional turbulence, emerging market equities remain cheap. As always, it pays to be selective when investing in emerging markets as the asset class is not a homogeneous group.
Investment Strategy Quarterly is intended to communicate current economic and capital market information along with the informed perspectives of our investment professionals. You may contact your financial advisor to discuss the content of this publication in the context of your own unique circumstances. Published 10/1/2021.