A tidal turn for emerging markets


In this article, I raise the unthinkable: emerging market indices could be on the verge of outperforming developed markets.

The MSCI Emerging Market index (MSCI EM) outperformed the MSCI World index (effectively a developed markets index) from 2000 but underperformed over 20 years and has been awful for the past decade, returning a paltry 10% versus over 100% for the MSCI World index.

Severe EM underperformance started after these stock markets hit their zenith in November 2007, one month before the official onset of the Great Financial Crisis (GFC), and they have never fully recovered, albeit flirting with new highs in 2021 before subsequently wilting.

Chart 1: MSCI EM vs MSCI World (10 years to 30 Sep 2023)

Source: Northstar and Bloomberg

But every dog has its day, so what will it take for emerging markets to rebound? The answer lies in dollar weakness and earnings growth.

Dollar weakness

With respect to EM performance, since 1998 there are really two distinct periods to consider. 1998-2008 was a decade of supercharged gains, and this was followed by more than a decade of underperformance. Both periods, not by coincidence, correspond perfectly with dollar movements (DXY index) – weakness in the first period, followed by a long and bumpy run of extreme dollar strength in the second. See the chart below.

Chart 2: MSCI EM vs DXY Index (to 31 March 2022)

Source: Northstar and Bloomberg

There are numerous reasons why a weaker dollar propels emerging markets, this article demands brevity, so we will cover the two main ones. Emerging markets, with dollar debt, benefit when the dollar weakens due to lower interest and capital repayments. Manufacturing based emerging markets have many of their input costs priced in dollars, so dollar weakness allows them to buy more of the same product per unit of dollar, which allows them to leverage their scale advantages profitably.

The dollar’s strength over the past couple of years is ascribable to the US’s exceptional growth story, a ‘flight to safety’, and aggressive interest rate increases from the Fed. We believe that many of these vectors are tired. A future world with a ‘relatively weaker’ dollar should surprise few.

Earnings growth

The other key to emerging markets outperforming is relative corporate profitability versus developed markets. The chart that follows illustrates this beautifully. From 2000 to early 2010, emerging market earnings growth was higher than that of developed markets, and emerging markets responded with a huge run-up that ended in late 2007, only to experience another leg up, which failed in mid-2010.

Chart 3: MSCI EM relative to MSCI World (to 30 September 2023)

Source: Northstar and Bloomberg

But can emerging markets produce elevated profitability again? Sentiment is overwhelmingly negative against this investment class: news flow is dominated by geopolitical tensions, trade wrestles with the West, and fears of hyper indebtedness by governments and consumers. None of this can be disputed, yet analysts are upgrading 1, 2 and 3 year earnings forecasts for emerging markets relative to their larger developed market peers as is evident from the chart 4 below.

Chart 4: Earnings growth estimates (2 year) (to 30 September 2023)

Source Northstar and Bloomberg

A blunt indicator of valuation is the price to earnings ratio (P/E), and whilst it certainly does not adequately deal with all the nuances on valuation, it does tell a story. The MSCI World index trades at a lofty premium of 26% to the MSCI EM, which is not far off the average premium that has existed since 2011. The earnings upgrades by EM market analysts should, given time, be reflected in a lower DM premium.

Chart 5: P/E ratio (to 31 October 2023)

Source: Northstar and Bloomberg

For beleaguered investors stuck in emerging market funds, your time for reprieve could be drawing near. This includes South African investors – it is true that our market has been a victim of its own goals due to our sociopolitical and economic failures, but the JSE has also been shunned through association with all emerging markets.

When this tide turns, it will do so for all small boats!