The best time to buy any investment is thought to be when: it has been out of favour for a long time; is cheap; has a catalyst for change; and, crucially, has begun to move - there are no prizes for being the first to spot a bargain if it remains one.
Emerging market shares appear to tick all of these boxes. This week, I ran a chart from just before the financial crisis, at the start of 2008. It showed that $100 invested in the S&P 500 index 18 years ago would be worth around $440 today. The same $100 invested in a basket of emerging market shares would be worth, you guessed it, $100.
Emerging markets have gone nowhere for nearly two decades. In part that reflects their starting point. Chinese shares, in particular, enjoyed a spectacular rally between 2003 and 2007, rising seven-fold in three and half years. It was always going to be hard to follow that. And it was impossible to do so in a world in which capital was heading in one direction only - towards the US.
That leads to the second criterion, valuation. Emerging markets shares are certainly some of the cheapest in the world at the moment, on a par with the UK’s own deeply unfashionable stock market, and a bit better value than both Europe and Japan. Compared to US shares, they are a steal, standing at a discount of more than 40 per cent, however you measure it - earnings, book value or dividend yield. That’s despite delivering a return on equity only about 15 per cent below the global average.
So, there’s a valuation argument. But being cheap is never enough. Why else might we invest in these out of favour markets? What are the catalysts for change?
Put it all together and you can see why analysts expect earnings for emerging market companies to grow faster than their developed market counterparts
The first is the end of the almost mystical belief in US exceptionalism. For a decade and more, investors have needed to look no further than Wall Street. Now, erratic and self-sabotaging policy, sky high debts and deficits, and tarnished institutions mean they are reluctantly lifting their gaze to the world beyond. Europe was the initial beneficiary but has lost its lustre over the summer. A continued rotation out of the US is likely to benefit developing markets more.
The reasons to be nervous about investing in emerging markets are also falling away. In a world of unsustainable fiscal pressures, their relatively low debt is attractive. They moved more quickly than developed countries to tackle inflation as we emerged from Covid, and there is scope in many markets to cut interest rates further. Current account balances are stronger than they were a decade ago.
At the start of the year, emerging markets were thought to be on the wrong side of the US’s changing trade policy. But investors now accept this was an over-simplification. Thirty years ago, 75 per cent of emerging market exports went to the developed world and 25 per cent to other emerging markets. Today, the two are almost in balance.
There are other reasons why investors can remain sanguine about tariffs. The Chinese stock market is surprisingly domestic. Around 85 per cent of the revenues of companies making up the MSCI China index come from China itself. Just 3 per cent are from the US. At the same time, ongoing technological innovation means that there are often only limited alternatives to Chinese products. It’s US consumers who are expected to swallow most of the cost of tariffs, not manufacturers.
Out of favour, cheap, with an identifiable catalyst, and momentum. Perhaps emerging markets can finally emerge.
Another key contributor to the case for emerging markets is the weakness of the dollar. The US currency has fallen by nearly a tenth this year. This helps emerging markets in a number of ways. It improves spending power for consumers; it reduces imported inflation; it lessens the burden of dollar-denominated debt; and it boosts the price of commodities, a key export for many emerging markets.
One of the reasons why emerging markets have underperformed is that they have not delivered the earnings growth that a higher rate of GDP growth would imply. Again, that looks to be changing. Beijing’s drive to persuade manufacturers to kick their long-established habit of competing on price is a work in progress. But it has the potential to end self-destructive oversupply in industries like solar panels and electric vehicles. Consumer subsidies are, meanwhile, boosting demand.
Elsewhere, Korea has launched governance reforms that mimic the successful cultural shift in Japanese boardrooms. Making directors answerable to external shareholders as well as founding families, promoting dividends and reforming inheritance taxes are important steps towards narrowing Korea’s valuation gap and, in due course, reclassifying it as a developed market.
Put it all together and you can see why analysts expect earnings for emerging market companies to grow faster than their developed market counterparts - by 14 per cent over the next 12 months, compared with 11 per cent.
You could have made many of these points before now. What’s different today is that an investment in emerging markets has momentum on its side. In the past three months, the MSCI China index has risen by 17 per cent, more than twice as much as the S&P 500’s 8 per cent gain over the same period.
In part the rally has been driven by liquidity rather than fundamentals. But that does not mean the outperformance is unsustainable. Chinese investors are sitting on a mountain of uninvested cash. Since the pandemic, household deposits have risen from 80 per cent of GDP to around 110 per cent. Over the same period the yield on deposits and bonds has tumbled. Property, the traditional home for Chinese savings, looks unattractive. Gold, another popular investment in China, has run ahead of itself. The stock market is the last man standing.
Out of favour, cheap, with an identifiable catalyst, and momentum. Perhaps emerging markets can finally emerge.
Tom Stevenson is an investment director at Fidelity International. The views are his own.
