In last month’s update to its World Economic Outlook, the International Monetary Fund (IMF) – in a slight upgrade to previous figures – forecast world GDP growth of 2.9% in 2023, down from an estimated 3.4% in 2022.
Within this, developed market economies are set to grow by just 1.2% – half the estimated rate for 2022 – while emerging and developing economies, buoyed by China’s post-lockdown reopening, are forecast to see a modest acceleration from 3.9% estimated growth in 2022 to 4% forecast for 2023.
While the numbers themselves look pretty lacklustre compared with average global economic growth of 3.8% a year between 2000 and 2019, they are at least heading in the right direction for emerging and developing economies, an area where this superior growth potential has long been seen as fundamental to the investment case.
But as Raj Shant, a client portfolio manager at global asset manager Jennison Associates, points out, economic growth can be far from the whole story for investors in emerging market equities.
“Empirically, you can see that over the last decade or two, GDP growth rates in emerging markets have on average comfortably exceeded those of developed markets, but market returns have largely done the opposite,” he says. Indeed, while the developed market MSCI World index has produced an annualised return of 9.6% over the 10 years to the end of January 2023, the MSCI Emerging Markets index has returned just 2.5% a year over the same period. “Emerging market investors with core, balanced or index funds are often disappointed to discover that the market is not the economy,” Shant adds.
As a largely growth-biased bottom-up fund house, Jennison’s EM portfolios tend to be less exposed to the areas of core financials, consumer staples and natural resources (once memorably described to this correspondent as ‘banks, booze and holes in the ground’) that have historically dominated emerging equity markets.
Instead, Shant says, “our view is that the reason economic growth in emerging markets regularly exceeds that of developed markets is that there are certain dynamic and innovative companies driving it”. He points to the continually rising share of global patents in China and India as representing genuine innovation, rather than the generic ‘copy-paste’ model that many may associate with these countries’ intellectual property.
Shant says around 60% of companies create little or no value over an average economic cycle, and may in fact destroy value, which could explain the disappointing returns for EM index investors over the past decade. Jennison’s investment strategy prioritises the top two quintiles of growth stocks, leading it to back companies in areas such as mobile payments – where emerging markets have led the world, given patchy penetration of both traditional banking services and fixed-line telecommunications.
Many emerging markets are set to benefit from China’s reopening, but also potentially from escalating tensions between China and the US, seen in the recent spy balloon saga and diplomatic scuffles over Taiwan. “There are all sorts of industries that people did not realise had Chinese exposure embedded in their supply chains until the lockdowns,” says Shant.
Whether as a result of business pragmatism or anti-Chinese sentiment, many manufacturers are adding or duplicating capacity in other locations. “If a global corporation needs a ‘China + 1’, they aren’t going to build that capacity in London or San Francisco; they are going to go to Vietnam or India or Mexico,” says Shant. “The market is realising there are a whole lot of opportunities being created that will benefit India first and foremost, but also countries like Turkey, Mexico and elsewhere in Latin America, where high-value jobs and exports will be created.”
However, while Jennison likes India’s structural advantages – including an education system that has produced some of Silicon Valley’s top executives – Shant says there can be periods where market valuations get ahead of earnings growth potential. “That’s largely where we are at the moment, but the market will grow back into its multiple,” he suggests.
Of course, ‘growth’ can come with risks in any market, as investors in Chinese internet and online education stocks will have been only too aware in recent years, and many fund managers still prefer the home-grown, domestically focused and often family-run companies that have underpinned the development of emerging stock markets. And with the past decade or so having been a particularly unusual period for investors given the low cost of capital, perhaps a longer view is also necessary.
Since 1987, the MSCI Emerging Markets index has in fact comfortably beaten the MSCI World, with an annualised return of 9.7% versus 8%, suggesting that broad exposure to these faster-growing economies can indeed pay off over time.
