Looking across the world and attempting to forecast expected returns over the next decade, I believe the best expected returns are found overseas. A recent analysis from Goldman Sachs shows that by 2075, China and India may be the two largest economies in the world. Long-term investors choosing to not invest in these regions while they are historically cheap, and instead pouring money into highly overvalued US indices is a mistake in my view. Now is the time to consider rebalancing into international markets. I reviewed the case against U.S. markets and for international stocks. Now I turn to why I believe the emerging markets offer investors a long-term opportunity to prosper.
Goldman Sachs Research
I believe the US will have the lowest return over the next decade just given where we are starting from. The US is followed by developed international markets, and then emerging markets, which I expect will outperform the US and International developed markets over the next decade.
The Case for Emerging Markets
I believe EM is the best place to invest for the next decade for a number of reasons.
First, EM stocks trade at historically low valuations compared to the US and even other international stocks. EM Stocks are trading for a P/E of ~12x earnings, vs the US market which trades at ~20x earnings. Wellington Management company furthers this analysis by looking at the Shiller cyclically adjusted P/E commonly known as the CAPE ratio.
“…the Shiller PE ratio for EM equites was less than half that of US equities (11.4 versus 27.5). The spread between US and EM Shiller PEs (16 points) is at the 86th percentile since 2005, meaning it has only been wider 14% of the time. The valuation advantage is a key component of our favorable 10-year CMA for emerging markets…”
Emerging markets currently trade for a steep discount to developed market equities. The chart below shows the relative P/E ratio vs the S&P 500.
Polen Capital
Further earnings are expected to outpace developed markets according to a recent analysis by Lazard Asset Management:
Following a sharp decline throughout 2021 and 2022, earnings growth expectations have moved higher for emerging markets compared to developed markets, including the United States (Exhibit 3). Within the standard MSCI EM Index, Asia leads all regions, followed by Europe, Middle East & Africa and Latin America. Within Asia, China internet platform companies, of which the biggest stocks are in media and entertainment and retailing sectors, are also among the bigger contributors to earnings growth. The sector has seen earnings upgrades and an improvement in profitability on the back of lower subsidies, cost cutting, and more cautious capital allocations.
Lazard Asset Management
Second, EM stocks are also from economies that are expected to experience rapid growth over the next decade. Consider the case study of India. According to a recent Reuters piece India is on pace to grow at a multiple to the rate of the U.S. economy stating: “The Indian economy is projected to grow at a 6.7% -7% rate in the fiscal year ending March 31, 2024.”
Reuters
Third, the historical evidence shows that emerging market stocks actually beat developed markets over the long run. A recent analysis from Wellington Management Company demonstrated this:
Historical evidence — It’s easy to forget after a challenging decade, but emerging markets have delivered stronger performance than developed markets over the longer term (Figure 2), albeit with more volatility. During the period shown in Figure 2, EM equities had a cumulative annualized return of 9.5% versus 7.9% for developed market equities.
Wellington Management Company
I do think investors need to be careful simply buying EM Index funds which are highly overweight China, leaving investors underexposed to other emerging markets. Emerging Markets is a broad term, but it includes a number of nations, some are better investments than others, and some styles of investing offer more opportunity than others. It is important to look at the EM ex-China market to discover all that EM covers.
Wellington Management Company
The low valuation on stocks in China reflects lower profitability. This is partially due to more state ownership which reduces the focus on profitability. When we look at profitability in the EM Ex-China segment, we see “EM ex-China presents a mixed profitability picture (margins in the five largest markets range from 6% to 22%), it has a significant edge over China. This reflects differences in sector composition, but also factors such as cross-sector governance and market structure.” –Wellington Management Company
Wellington Management Company
I believe investors will do best in EM over the next decade by focusing on small cap, value, and high profitability stocks. We have already seen value outperform growth as the rally in EM gets underway. I expect this trend to continue.
Bloomberg
Opportunities in EM Bonds
It is not just EM equities but also EM debt that I expect will do well. According to an analysis from Lazard Asset Management, EM debt is an asset set to outperform in the year ahead.
As we enter 2024, we maintain a constructive outlook on EMD amid a backdrop of ongoing monetary cycle easing. Fixed income markets historically tend to generate equity-like returns during the period between the end of central bank rate hikes and the completion of rate cuts. We expect this trend to continue as major global central banks have concluded their rate hike cycles, with inflation remaining better than expected and labor markets loosening.
Key macroeconomic trends shaping our base-case scenario for 2024 include:
The European Central Bank (ECB) and the Federal Reserve initiating a traditional cycle of rate cuts in mid-2024, extending into mid-2025.
Developed markets growth stagnating at near 0% in the first half of 2024, with only tepid improvement in the second half of the year.
Emerging markets growth picking up in the second half of 2024 as a result of significant policy easing enacted in 2023 and 2024, with leading EM economic indicators bottoming out around mid-2024.
EM debt continues to have high yields in the low double digits in some markets. These higher yields create a huge opportunity for income seeking investors who are willing to take on the risk of EM bonds.
Lazard Asset Management
Additionally, flows data gives us positive signals as momentum in the EM bond market continues to show that this is an asset class that can outperform. Several opportunities exist in a year that is going to see a number of elections across EM.
Lazard Asset Management
Conclusion
International stocks offer investors better valuations than U.S. stocks, but the emerging world offers investors a compelling case for investment over the long run. Surely EM stocks come with a number of risks from political risks to currency risks. However, I believe investors should be well compensated for taking these risks in EM given the strong tailwinds of growth and low valuation levels. Some funds to consider for investment will depend upon one’s individual goals and objectives. Speaking generally, investors would be wise to seek out funds that target the styles of investing I believe will do best going forward. Namely, value, small caps, and high profitability stocks. To capture the factor premia from these areas, consider adding some of the following:
Value
Avantis EM Value/DFA Emerging Markets Value (AVES)/(DFEV)
