James Corkin, Steyn Capital Management
Markets, like many other phenomena driven by human behavior, tend to move in cycles. Humans, on the other hand, have a tendency to extrapolate recent history into the future and as investors this kind of thinking can get you into trouble. Wayne Gretzky, who many deem to be the greatest ice-hockey player ever to play the game, famously quipped “I skate to where the puck is going, not where it has been”. As investors, it’s critical that we too consider where the puck is, and where it might be going.
Since 2010, the metaphorical ‘puck’ has been in the US, and the “Mag 7” in particular. Investors who ignored every other market globally and simply invested in the S&P 500 fourteen years ago would have done exceptionally well. While that investment strategy was enormously successful for the last 14 years, those investors hoping it will be repeated for the next decade might very well be disappointed. On a variety of metrics, US valuations are stretched to levels only seen at a handful of extremes in financial history, none of which boded well for investors or their portfolios. Given where we find ourselves today, with many investors overweight US equities on the basis of where the puck has been, this might be an opportune time to consider where in fact the puck might be going.
So where’s the puck going?
Emerging Markets by contrast are extraordinarily cheap. Since its inception in 1988, the Emerging Markets index has never in four decades been as cheap relative to the S&P 500 as it is today. In fact, the last time Emerging Markets came close to this level of comparative cheapness (in the period 1998-2000) it preceded a bull market where Emerging Markets outperformed the S&P by 18% per year for the subsequent nine years.
An important variable to consider when talking about Emerging Markets is the US Dollar. The Dollar has a long-established inverse correlation with the performance of Emerging Markets, which is another way of saying that a strong Dollar has historically been a headwind for Emerging Market equity returns. Similar to US equities, after a long period of US Dollar strength, the US Dollar also finds itself close to historical highs on a variety of metrics – despite a number of factors threatening the sustainability of such strength, such as the long-awaited rate cutting cycle which has now begun, ever increasing concern over the US Government’s fiscal position and even the possibility of a Trump presidency, who has been outspoken in his calls for a weak US Dollar.
From this starting point Emerging Markets are looking extremely attractive. If history is anything to go by, when Emerging Markets do begin to outperform, this outperformance has historically been substantial and multi-year.
Emerging Markets are a long-term growth story
In the years ahead, Emerging Market economic growth, buoyed by healthier demographics and rising per capita GDP, will continue to outstrip developed markets. In the next 50 years, it is estimated that today’s “Emerging Markets” will make up 7 of the top 10 largest economies in the world. This shouldn’t be surprising, given over 80% of the world’s population today lives in an Emerging Market, which in turn are continuing to benefit from more youthful demographics than their developed market peers, urbanization trends and rising per capita incomes.
Emerging Markets already comprise over 40% of Global GDP, yet, despite their significance and outlook, Emerging Market stocks make up a mere 30% of the worlds listed stock market value. Global Index representation is even lower at around 10% and most global investors have even less exposure at around 6% – a clear under-allocation even relative to Emerging Markets’ current significance.
But if Emerging Markets are indeed to become the largest economies globally in the decades ahead, which we believe they will, the investor under-allocation above is even more extreme than it appears and presents a compelling opportunity for savvy investors.
The problem with going passive
While passive strategies or indexing is an efficient, sensible and low-cost way to access Developed markets equities, the same is not necessarily true for Emerging Markets, where passive strategies have some significant limitations.
The Emerging market index is dominated by only four countries which comprise over 75% of the index – China, Taiwan, India and South Korea – and two of these countries (Taiwan and India) are also by a significant margin the most expensive markets within Emerging Markets. There is a long tail of Emerging Market countries not meaningfully represented by the index (and hence overlooked by global investors), where valuations are at rock-bottom. The most compelling opportunities in Emerging Markets are often not the index heavyweights (where some problems can lurk for passive investors – a recent case-in-point being the issues at PDD).
At Steyn Capital, for example, we spent 11 years creating a proprietary investment universe of only the highest quality companies within Emerging Markets, which is a key competitive advantage in identifying the best opportunities to research within these markets.
The last fourteen years have set the stage for an exciting multi-year opportunity in emerging markets, but quality remains crucial in navigating the invariable bumps in the road. Our work over the last eleven years to identify these businesses, we believe, makes the current starting point even more compelling.