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Four reasons for perseverance in Emerging Markets (EM)
We are at the beginning of a more favourable monetary policy backdrop
- Key EM economies are expected to cut rates in the next two years: China, India, Indonesia, Korea, Taiwan, Brazil, Mexico, and South Africa. Together they represent 86% of the index.1
Chinese share prices will revert back to fundamentals and there is a significant valuation opportunity
- Despite delivering solid earnings growth, Chinese stocks derated in 2023, creating a dislocation between fundamentals and valuation. We delve into the opportunity it presents in more detail in pages 3-5.
India will help drive forward the earnings growth and performance of EM
- India’s weight in the MSCI EM Index has almost doubled.2
- India has a performance gap vs. EM of almost 90 percentage points and 33 percentage points against the S&P 500.3
- MSCI India delivered 69% earnings-per-share (EPS) growth vs. 35% for the S&P 500.4
In the past four years:
EM technology will go from strength to strength: Information technology (IT) represents 22% of the index and 32% of our strategy5
- IT has been the best performing sector in EM over the long term.6
- EM technology stocks are expected to deliver earnings growth of more than triple the US (almost 60% vs. 17% in the next two years), whilst trading at a 40% discount to US technology.7
- MSCI India delivered 69% earnings-per-share (EPS) growth vs. 35% for the S&P 500.4
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The problem is not fundamentals. The problem is valuation.
Challenges in 2023 have created opportunities for 2024 and beyond
Style headwinds impacted performance with the strongest outperformance of value vs. growth in a quarter of a century.8
- In particular, quality growth was challenged in China where, amidst broadly falling markets, state-owned/value stocks outperformed private/quality growth stocks. With a more accommodative central bank environment globally, we expect the market to reward quality growth companies once again
Technology was the most significant contributor to the portfolio’s performance in 2023.9
- Our overweight to the sector and stock selection supported performance, particularly semiconductors, hardware, and IT services. Even following from a strong 2023, we expect a continuation of strength in the sector, given the earnings growth outlook and valuation discount relative to US technology.
EM is a heterogenous asset class which captures a wide range of opportunities. In 2023, key emerging market countries posted positive returns with the exception of China. While China challenged our traditional EM model, our EM ex. China portfolio had strong relative returns for the year.
- We have high conviction in India and Korea in particular. India should benefit from the expanding middle class and increased in infrastructure, while Korea is home to some of the most cutting-edge technology companies in the world.
Table 1. MSCI Country Index Performance of Largest EM Countries in 202310
Given the challenging environment, what is our team’s view on China?
It is important to set the scene in China. The economy is delivering growth, but the pace of growth has disappointed. Slowerthan-expected growth is the result of property sector woes, which are dragging fixed asset investment and dampening consumer confidence and activity as Chinese citizens feel the negative wealth effect of falling property values.
The Martin Currie EM strategy is heavily skewed towards quality growth, privately-owned enterprises compared to the MSCI index. Roughly a third of publicly traded Chinese stocks are state-owned enterprises (SOEs), which have been supported by the Chinese government and are not widely held by foreign investors. As a result, quality growth companies have fallen more than their SOE peers, despite delivering solid fundamental operations (i.e., earnings growth). Essentially, the selloff is due to weak sentiment and high quality growth companies have borne the brunt of the selling pressure.
Chart 1. Performance of SOEs and non-SOEs in China
Source: J.P. Morgan research (Refiniv Eikon Datastream, Bloomberg, J.P. Morgan, 29 November 2023).
What are we seeing from our Chinese holdings? Where do we stand today?
The problem is not fundamentals.
The deeply negative sentiment that surrounds China has resulted in a significant fall in share prices. Yet, we continue to see stable to strong fundamentals in our Chinese holdings. There is a dramatic divergence between the solid fundamentals of the businesses we own (i.e. sound operational delivery) and the extremely weak share prices we have seen of late.
Table 2. Earnings growth and share price performance of Martin Currie EM strategy Chinese holdings in 2023
Source: Bloomberg and FactSet, as at December 2023. EPS = Earnings per Share, based on FY2023 estimates. Companies shown in order of active weight in our strategy portfolio. *Extraordinary items excluded from calculation.
The problem is valuation.
The price that the market is willing to pay for Chinese businesses has significantly derated as shown by these valuation bands for our portfolio. This valuation situation in China is extremely stark. The only parallel we can find in modern history is the global financial crisis – when the situation was dramatically worse. Although China faces confidence issues, we believe the negativity has gone too far. We expect share prices to follow fundamentals again as investors recognise the historic upside opportunity.
Table 3. Projected earnings growth and valuation analysis for Martin Currie EM strategy Chinese holdings
Source: Bloomberg, January 2024. *Meituan shows the P/B multiple instead of P/E due to data availability. Companies shown in order of active weight in our strategy portfolio.
Summary
In summary, EM continues to be an exciting area for opportunity, especially for quality growth investing. While we’ve experienced the largest rotation from growth to value in the past 25 years, we believe that investing in world class businesses positioned to take advantage of strong secular growth opportunities across emerging markets will be the long-term winners.
Perhaps the biggest opportunity from a valuation perspective might be Chinese quality and growth companies, where they are trading at steep discounts, especially in our portfolio. The current valuation multiples of the Chinese companies held in our strategy portfolio are at a c.50-70% discount to 5-year averages.
This presents a significant valuation opportunity for businesses with positive earnings outlooks and that have delivered strong operational performance. We are confident that the dislocation between fundamentals and valuation cannot last indefinitely and that there will be a shift in sentiment towards Chinese companies in 2024. This shift will be a significant turning for Chinese equity markets and, given the allocation of China within EM, will be a key positive for the asset class more broadly.
While the China opportunity is compelling, there continue to be exciting companies in EM outside of China. There were several countries that outperformed the US market last year and India, in particular, has outperformed the US over the past four years. We believe it is in a great position to continue delivering earnings growth and driving EM returns.
Finally, technology has been the big winner in emerging markets over the past decade and will continue over the long term, given the ability for EM IT companies to innovate and stay on the front foot of technological advancement. The opportunity is especially apparent from the valuation discount and earnings expectations relative to US technology companies.
Sources
1Source: Martin Currie and MSCI, as at 31 December 2023.
2Source: FactSet. From 8.6% in December 2019 to 16.7% in December 2023.
3Source: FactSet, from 31 December 2019 to 31 December 2023 MSCI India net total return was 80% versus 47% for the S&P 500 and -8% for MSCI Emerging Markets.
4Source: FactSet, from 31 December 2019 to 31 December 2023. 2023 EPS based on consensus earnings estimates.
5Source: Martin Currie and MSCI, as at 31 December 2023.
6Source: FactSet, from 31 December 2014 to 31 December 2023. Over this period the MSCI EM IT sector generated a return of 256%.
7Source: FactSet, 19 January 2024. Valuation of 17x NTM P/E for EM vs. 28x NTM P/E for the US.
8Source: Morningstar, as at 31 December 2023.
9Source: Martin Currie and MSCI, as at 31 December 2023. Data presented is for the Martin Currie Global Emerging Markets representative account. MSCI Emerging Markets Index used as benchmark.
10Source: Martin Currie and MSCI, 31 December 2023. Index weight as at the end of the period, shows countries with an index weighting of >2%.
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