It is hard to ignore the returns provided by the U.S. equity market in recent years. Equity has advanced at an
incredible pace and provided a tailwind that most market experts agree is likely to slow in the coming years.
Massive amounts of liquidity, declining interest rates and robust economic growth combined to fuel this
historic run. Where will the next generation of investors find such potential returns?
Investors may be wary of emerging markets
The U.S. economy expanded steadily for many years
on the strength of population growth, a position as
the world’s leader in innovation and technology,
and an ever-wealthier consumer base. We believe
the U.S. and other developed economies still offer
potential investment opportunities, but many of the
underlying structural growth drivers are slowing.
By contrast, emerging markets still are early in their
development. A growing consumer population with
increasing wealth, improving economic and corporate
fundamentals and an explosion of new industries
offer the potential for investment in a wide range of
companies. The U.S. and China offer an example of
the differences in growth rates over time, as shown
in Chart 1.
Despite some of these well-documented trends, there
still is negative sentiment among many investors
toward emerging markets. It’s common for individuals
to take recent events and extrapolate them to the
future. This behavioral tendency, known as “recency
bias,” is prevalent in investing. A common recency
bias today has led many investors to believe that
they can’t “make money” in emerging markets.
The volatility of recent years has caused those
investors to overlook longer-term returns in emerging
market equities. For perspective, Chart 2 shows an
investment during the 2000s in emerging market
equities would have had an 8.82% annualized return,
exceeding developed market returns in that period.
Chart 1: China per capita GDP forecast to grow 7.82% annually while U.S. growth slows
Source: International Monetary Fund, per capita gross domestic product, 1988–2018, *2024 forecast.
CAGR = compound annual growth rate. Past performance is no guarantee of future results.
Chart 2: Emerging market equities outperformed developed market equities since late 2000
Source: Morningstar Direct; annualized returns for period 01/01/2001 to 10/31/2019; emerging market
equities represented by MSCI Emerging Markets Index, large-cap U.S. equities represented by S&P 500
Index, small-cap U.S. equities represented by Russell 2000 Index, and international equities represented
by MSCI EAFE Index. It is not possible to invest directly in an index. Past performance is no guarantee
of future results.
Volatility can be expected in emerging market equities
because those countries generally are earlier in their
lifecycles and often are less stable and prone to political
and economic shifts. However, the fact that they are
earlier in their lifecycles leads us to believe they present
opportunity. Recently, geopolitical events and a barrage
of negative headlines have caused many investors to lose
their long-term perspective on emerging markets and
sell the asset class. Misguided human behavior often can
create opportunity, particularly in investing. We believe
this has the potential to be such a situation.
Strong fundamentals prevail over time
As global economic growth decelerates, we think
the long-term fundamentals of emerging markets
look more attractive. There are clear and visible
drivers of this growth:
- Innovation: Investing in emerging markets, for the
greater part of the last 20 years, was largely focused on a
narrow universe of state-run energy, financials, utilities
and telecommunications companies — essentially,
the basic needs of a country. In recent years, there has
been a dramatic shift in the profile of emerging market
industries, as shown in Chart 3. Technology, consumer
and other “new economy” companies have grown in
quantity and size. Much of this growth is attributable to
China, whose large economy has provided the capital
and scale for many of these innovative companies to
grow into some of the world’s leading businesses.
Chart 3: Emerging markets shifting to new economy sectors
Source: FactSet; percent of the MSCI Emerging Market Index represented by each sector. It is not possible
to invest directly in an index. Past performance is no guarantee
of future results.
- Mobile technology: The buck stops with China when
it comes to mobile. It is home to nearly 800 million
mobile internet users¹ and is the world’s largest
manufacturer of smartphones.
- Memory chips: Memory chips are crucial in a datadriven
world. South Korea is home to Samsung
Electronics Co. Ltd. and SK Hynix, Inc., two of the
world’s largest memory chip manufacturers.
- Semiconductors: 40% of the world’s semiconductors are
made by three major emerging market-based producers.
- Mobile payments: China’s mobile payments industry is
50 times that of the U.S.1
- Consumption: Export-led growth has been the foundation
of many emerging markets, but consumption is the new
paradigm. At the peak in 2006, China’s exports as a
percent of gross domestic product was 36%, but as of
2018 had dropped to 19.5 %.² Less reliance on exports
is an important economic shift, particularly in times of
global trade uncertainty.
- Valuation: Because the underlying structural factors
driving emerging market growth remain solid, we
believe the valuation gap between companies in
emerging markets and the U.S. is likely to narrow.
Emerging market valuations are at a discount to
the U.S., as shown in Table 1. Valuation alone will
not support price appreciation in emerging market
equity, but we also expect earnings-per-share growth to reaccelerate. Earnings growth in emerging markets
trailed the U.S. in 2018 and 2019, but there are market
expectations for it to regain a higher rate of growth.
Table 1: Emerging markets valuations below U.S.
Sources: Valuations, Star Capital AG; Earnings data, FactSet. Emerging market equities represented by MSCI
Emerging Markets Index, U.S. equities represented by S&P 500 Index. It is not possible to invest directly in an
index. CAPE = cyclically adjusted price to earnings, which uses real earnings per share over a 10-year period
to smooth fluctuations in corporate profits over the business cycle; P/E = price to earnings; P/B = price to
book; P/S = price to sales; EPS = earnings per share. Past performance is no guarantee of future results.
- Reform programs: Reforms have been positive catalysts
in many emerging markets and we think this will
continue. Recent examples include Brazil and India,
where both are focused on structural reforms. We
believe these measures in both countries are likely to
reshape fiscal imbalances and support sustainable
economic growth. In addition, we think these combined
actions make their banks much better positioned to
weather future credit events or market shocks.
The investor's dilemma: Active or passive?
The debate between proponents of active and passive
investing styles may never be settled. The recent period
of cheap money has distorted many fundamental
characteristics of companies and led many to question
the growing dominance of passive investing. We believe
there are asset classes in which investors may benefit
from an active management approach, and emerging
markets is one such asset class. We think there are
fundamental problems with passive investing in
- State Owned Enterprises (SOEs): We recognize that all
SOEs are not bad. Some are longstanding, well-run
companies with dominant market share. Because
these companies typically are so mature and have
high market share, they are large companies with big
market capitalizations and large allocations in the
major emerging market index. However, they can be
inefficient capital allocators and often are not good
stewards of shareholder capital. We therefore think
many of these companies should be avoided. There are
six SOEs in the top 20 holdings of the MSCI Emerging
Market Index, meaning passive investors can’t avoid
investing in them.
- Chinese A-Shares: By November 2019, the MSCI
Emerging Market Index will include 253 large-cap
and 168 mid-cap China A-Shares stocks. These are
the domestic shares that trade on the Shanghai and
Shenzhen stock exchanges. As the index increases the
allocation to China A-Shares, it opens a new potential
risk to passive investors. The China A-Shares market
has many highly indebted and poorly run companies
with governance and transparency issues. Shares in
some of these companies also tend to be volatile. In our
view, these are companies that many investors would
not want to own. However, it is important to note that
there are well-run China A-Shares companies, too. An
active strategy based on fundamental research can
analyze each holding and be selective, unlike a strategy
that simply tracks the index.
- Governance: Less transparency among companies
in the emerging markets requires expertise and due
diligence to recognize those with potential and avoid
the poor ones. Exchange traded funds (ETFs), driven
by quantitative metrics and market capitalization,
are disadvantaged when it comes to discovering
key company characteristics that are important
for investment success. Active strategies can avoid
governance issues that can result in value destruction.
- Country/currency risk: The immature nature of emerging
market economies can lead to progress as well as
disruption. Being aware of these changes and having
the ability to manage these risks can provide value
Changing landscape can present opportunities
We believe emerging markets present an important
opportunity for investors. The landscape has changed
dramatically and we think there are abundant
opportunities. Emerging market equities remain
relatively cheap on a valuation basis when compared to
developed markets, and we think a likely reacceleration of
earnings growth will support a valuations increase. While
many investors have been reluctant to invest in this asset
class, we believe most fundamental and investment
characteristics argue in favor of a strategic allocation to
emerging market equities. In our view, exposure to these
regions through an experienced active manager has the
potential to generate attractive long-term returns.
1 Source: The Economist, “Why Americans are warming to mobile payments,” 06/26/2018
2 Source: World Bank
The MSCI Emerging Markets Index is an unmanaged index comprised of securities that represent large- and mid-capitalization companies within emerging market countries. The S&P 500 Index is a float-adjusted
market capitalization weighted index that measures the large-capitalization U.S. equity market. The Russell 2000® Index is a float-adjusted market capitalization weighted index that measures the performance of
the small-capitalization segment of the U.S. equity universe and includes approximately 2,000 of the smallest securities. The MSCI EAFE Index is a free float-adjusted market capitalization weighted index designed to
represent the performance of large- and mid-capitalization securities across 21 developed market countries in Europe, Australasia and the Far East. It is not possible to invest directly in an index.
Holdings as a percent of net assets as of 09/30/2019 in the Ivy Emerging Markets Equity Fund: Samsung Electronics Co. Ltd., 6.65%; SK Hynix, Inc., 0.64%
Past performance is no guarantee of future results. The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future
performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a
general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on
an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Risk factors: Investment return and principal value will fluctuate and it is possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic
conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. These and other risks are more fully described in a fund’s