Over the past year, emerging market (EM) equities have been one of the most volatile segments of the global market. With news headlines dominated by the International Monetary Fund’s bailout of Argentina and Turkey’s sudden interest rate increase and currency depreciation, EM equities dramatically sold off in 2018 – down 14.6% for the year (source: MSCI Emerging Markets Index). Investors sold billions of dollars of EM equities and market pundits raced to declare an EM crisis, one worse than 2014 and perhaps on par with 1997–1998. The fear has been palpable.
However, at Research Affiliates and PIMCO, we see two overarching reasons for long-term investors to consider continuing to hold a strategic allocation to EM equities: fundamentals and valuations.
Fundamentals don’t justify the fear
In our view, the biggest risk when investing in an EM equity market is a funding crisis, when a company or government borrows in U.S. dollars and investors lose trust in its ability to cover interest payments. We think the risk of a broad-based funding crisis in EM, especially the kind that affects the largest EM equity markets, is low.
First, the global economy, although decelerating, remains in many ways more stable than it has been in decades: Poverty has declined, inflation has trended downward and crises in banking, currency or sovereign debt have been less frequent. Second, since 2000, major EM countries have become wealthier and financially healthier as measured by cumulative GDP growth: China is up 60%, India 41%, South Korea 24% and Taiwan 22%. And as wealth has increased, foreign exchange (FX) reserves have grown – the average EM reserve level is approaching 25% of GDP today. (All data is from Research Affiliates and the World Bank.)
Finally, the largest constituents of the EM equity universe have the best fundamentals. China, South Korea, Taiwan, India and Russia make up nearly 70% of the MSCI EM Index. All have low external-debt-to-GDP ratios, ample FX reserves and current account surpluses (India has a tiny deficit). Another 17% of the market consists of Brazil, Mexico and South Africa, countries with current account deficits but low debt ratios and ample FX reserves. The countries driving the “EM funding crisis” headlines over the past year – Argentina, Turkey and Indonesia – make up less than 3% of the EM equity market. In fact, Argentina isn’t even an MSCI EM Index constituent. In short: We believe the largest EM equity markets are not at risk of a funding crisis.
Valuations appear attractive for the long-term investor
Before the 1997–1998 EM funding crisis, the EM equity CAPE (cyclically adjusted price-to-earnings ratio), a valuation metric useful over long periods of time, traded at a premium to the U.S. equity CAPE. Today, the EM equity market is priced at a CAPE of 14.5, at the bottom quintile of its historical valuation range and less than half the U.S CAPE of 29.6 (source: Research Affiliates). PIMCO’s five-year capital market assumptions forecast higher annualized returns in the EM equity market versus U.S. equities.
When the risks and the bad news are well-known to the market and fear reigns supreme, we believe opportunity abounds for the long-term investor. However, while we see favorable fundamentals and valuations, investors should not dismiss the risks – which can be sudden and severe – associated with the EM equity market, which has both rewarded and bewildered many investors.
For detailed insights into our views on equities, fixed income and other asset classes, please read our latest Asset Allocation Outlook.
Chris Brightman is chief investment officer at Research Affiliates, a subadvisor to PIMCO. Raji Manasseh is an equity strategist at PIMCO.