Long-suffering emerging markets fund managers are looking to party like it’s 2004. That was a so-so year for the U.S. The invasion of Iraq bogged down, and the Standard & Poor’s 500 index crept forward by 7%. But for developing-world stocks, it was the second year of a five-year run of strong outperformance. The MSCI Emerging Markets Index increased by nearly five times from October 2002 to October 2007, while the S&P advanced a mere 88%.
Two years into a new emerging markets rally that started in early 2016, partisans of the asset class are hoping for something similar. It’s “a new dawn” for emerging market stocks, proclaims old-school global investor Barings. Corporate profits in the developing world are soaring, valuations still lag historical averages, and external risks—namely, the threat of Donald Trump blowing up the global trade system—are receding.
Wall Street is, by and large, buying this bullish line. But it’s worth noting some key differences from emerging markets’ last big winning streak. Most obviously, global markets also came out of a slump in 2002 and headed north for the next five years. By contrast, the dawn of 2018 finds the U.S. on a nine-year bull run that most analysts expect to correct before too long.
Could emerging markets “decouple” from a U.S. downturn? Bulls note that growth depends less on exports to the U.S. these days and more on China and internal markets. But arguments like this have meant little during previous global shifts to risk-off psychology. Emerging markets were also growing much faster during their mid-2000s glory days: upward of 6%, compared with 3% to 4% now, according to UBS research.
THE LESS OBVIOUS DIFFERENCE is in the composition of emerging market stocks. The energy and materials sectors’ weighting has slid from 40% to 14% over the past decade, while information technology has surged to 30%, according to Templeton. The past year’s rally has been driven by a small group of Asian tech stocks that some call the TATS: Tencent Holdings (ticker: 0700.Hong Kong), Alibaba Group Holding (BABA), Taiwan Semiconductor Manufacturing (TSM), and Samsung Electronics(005930.Korea). That leaves the asset class less linked to commodities, but more vulnerable to a global tech downturn.
Emerging markets bulls do make a solid fundamental argument: Corporate profits are growing healthily after five ugly years of contraction from 2011-16. “We believe the recovery in profit margins is largely noncyclical,” Barings analysts write. “Productivity growth is outpacing real wage growth.”
Macroeconomic houses have been put in order, with reduced current-account deficits and subsiding inflation, which allows developing-world central banks to loosen credit while the U.S. and Europe tighten. In Brazil, inflation has sunk to a record low and the prime rate has shrunk from 14% to 7% this year.
The concentration of last year’s gains in China and tech has a bright side—allowing lagging countries like India or sectors like consumer staples to shine in 2018, says Nick Robinson, who helps run Aberdeen Asset Management’s emerging markets portfolio out of London.
In many respects, emerging markets’ past mistakes and misfortunes have transformed them into the grown-ups in the global financial room. Violent mood swings and unpredictable outbursts are more likely these days from so-called highly developed governments and markets. But the developing world doesn’t yet have the autonomy to ignore these tantrums. Proceed with caution.
Craig Mellow, Barron’s, December 9, 2017.