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By Neal Smith, 29 January 2016
We believe the key is to focus on alternative investment strategies with strategic advantages that can thrive even in a low-growth world, such as emerging markets (EMs).
Since 1970 EMs have outperformed developed markets. While the MSCI EM index shows an annualised return of 11.3% per annum up to November 2015, the annualised return of the MSCI World index was almost half, at 6.6%. Expressed as amounts, if had you invested $1 million into EMs back in 1970, the value of that portfolio would now be $134 million; the same amount invested in developed markets would be worth only $17 million.
But returns don’t come in a straight line, as the more recent returns of EM companies show.
Investors who jumped into emerging markets (EMs) after 2010 experienced a bumpy ride with emerging markets significantly underperforming their developed market counterparts. We are now five years into an EM bear market and it would be fair to say that EMs are very much out of favour. EMs have derated considerably relative to developed markets and valuations are currently looking very favourable.
According to the IMF, EMs now have the lion’s share of global GDP, and have overtaken that of developed economies. It is interesting that the IMF expects EMs’ share of global GDP to increase at an ever faster pace going forward.
Unlike developed markets where ageing populations pose strong headwinds to economic growth, EM economies are expected to have much more positive future growth prospects, as populations are typically much younger and faster growing. Furthermore, the trend of rapid urbanisation is very positive, as established cities tend to dominate global economic activity, boasting considerably higher disposable incomes and wealth.
As countries move up the development curve, their stock markets typically grow, resulting in a rising ratio of market capitalization to GDP. In other words, we expect EM stocks to continue their trend of outperformance going forward. If EMs can support their demographic and urbanisation advantage with good economic policies, access to education and healthcare, they can unlock what is popularly known as their “demographic dividend”, which would be a very powerful driver of future growth.
EMs also have an abundance of natural resources and boast the vast majority of the world’s population. This, combined with positive demographics and rapid urbanisation, should support strong growth in EMs going forward.
Historically, EMs have been excellent diversifiers. Although EMs generally remain somewhat more volatile than developed stock markets, investors should be able to achieve greater diversification benefits and improved risk return profiles by adding EMs to their portfolios (up to around 50% for optimal diversification benefits).
South Africa represents a mere 0.9% of global GDP, making it a relatively small investment destination. Up until recently, investors in the SA stock market have enjoyed strong relative returns due to a significant rerating. However, South Africa is now considered expensive compared to other emerging markets, and to developed markets. With a weak domestic growth outlook, expensive valuations and the rand not oversold relative to other EM currencies, there is better value to be unlocked offshore.
We believe EMs cannot be ignored; they account for 82% of the world’s population and 55% of the world’s gross domestic product. They are currently out of favour and undervalued, but it appears the worst could be over and we believe now is the time to be bold and allocate capital selectively.
The positive momentum of EMs, coupled with attractive valuations, gives long-term investors the opportunity to earn attractive risk-adjusted returns, while diversifying portfolios. The focus should be on selective stocks that are undervalued and best positioned to benefit from the structural growth drivers that have long made EMs a compelling investment destination.