Roughly 160 of the world’s nearly 200 countries are considered emerging markets (EM), and approximately 6 billion people, or 85% of the world’s population, live in emerging economies (map, below). Thus, there are plenty of reasons not to ignore emerging markets in a portfolio. But there are special considerations unique to emerging markets. These include currency movements, different political and legal systems, greater exposure to commodity prices in some cases, and periodic debt troubles. However, none of this is new, and many emerging markets are evolving from immature, rapid growth toward more mature, slower growth. Even though growth may be slowing in the EM and unique risks exist, we should still consider EM opportunities because these markets appear to offer better value than developed markets (DM) now and because emerging markets appear well-positioned to capitalize on a rebounding global economy post-COVID-19.

Emerging Markets

Emerging = Blue
Developed = Grey

Converging Growth

It is crucial to understand that the EM, while still growing faster than the developed world, is no longer growing as it once did. The chart below shows how EM is converging toward lower DM growth rates (Chart A, below). The largest two contributors to the EM downshift are productivity and labor. According to the Conference Board, EM productivity growth fell to -0.5% in 2019 from 1.5% average growth between 2000-2007. At the same time, labor growth slowed to 0.3% in 2019 from 0.8% in 2000-2007. Taken together, slower growth in productivity and labor is bringing EM growth rates closer to those of mature economies.

Better Value?

Even though EM growth may be slowing, we should consider EM opportunities because they seem to offer better value. To see why, we can look at the total value of a market’s stocks, plus net debt, versus sales. This ratio is called an “enterprise value to sales” (EV/Sales) ratio. It is a broad measure of value that considers both creditor and equity owner interests as providers of capital.

The US stock market has had an EV/Sales ratio between 1.5-3X for most of the past 25 years. Today the S&P 500, proxy for the US stock market, trades near the top end of that range. By contrast, the emerging market EV/Sales ratio ranged between 1-2.5x for the past 25 years. Today, the EV/Sales ratio for the EM is near 2x, easily inside the historical range (Chart B, below). All else equal, a better starting valuation is positive for future returns.

Chart B
Comparing Valuations (EM vs. Domestic Stocks)

Positioned for Growth Rebound

Emerging markets are far more sensitive to upturns in the global business cycle. The greater sensitivity is because a large share of EM economies is based on producing goods and raw materials. By contrast, developed economies tend to focus on less cyclical services. When global surveys of manufacturing activity turn down or up, EM stocks tend to respond. If the worldwide outlook for growth continues to make progress and COVID-19 worries begin to fade, growth should pick up, providing a powerful tailwind for emerging markets. Our analysis of incoming data suggests that growth continues to improve based on the most recent update of our WCA Barometer (Chart C, below).

Chart C
WCA Conditions Barometer

While we cannot know with certainty how the next few months will pan out, existing data point patterns to continued recovery. It is also worth noting that EM versus DM equity markets’ relative performance is starting to show signs of lift (Chart D, below).

Chart D
Emerging vs. Developed Market Relative Performance

Conclusion

So although growth rates between emerging and developing economies seem to be converging, we should position portfolios for better emerging market performance for two main reasons now. First, emerging markets appear to offer better relative value than developed markets. Most importantly, EM is well-positioned to benefit if global growth continues to pick up, especially if COVID-19 worries fade.

Could the case for emerging markets come undone? Of course, it could. Yet, the stars appear to be aligning for potential outperformance in the months ahead. We will continue to track and challenge our key assumptions underlying our bullish tactical case for EM. But so long as we continue to see progress in critical areas of the global economy, the case for EM is likely to remain intact.


Disclosures:

WCA Barometer – We regularly assess changes in fundamental conditions to help guide near-term asset allocation decisions. Analysis incorporates approximately 30 forward-looking indicators in categories ranging from Credit and Capital Markets to U.S. Economic Conditions and Foreign Conditions. From each category of data, we create three diffusion-style sub-indices that measure the trends in the underlying data. Sustained improvement that is spread across a wide variety of observations will produce index readings above 50 (potentially favoring stocks), while readings below 50 would indicate potential deterioration (potentially favoring bonds). The WCA Fundamental Conditions Index combines the three underlying categories into a single summary measure. This measure can be thought of as a “barometer” for changes in fundamental conditions.

Standard & Poor’s 500 Index (S&P 500) is a capitalization-weighted index that is generally considered representative of the U.S. large capitalization market.

S&P Global (SPGI) is a leading American provider of financial information, analytics, and credit ratings, headquartered in New York, NY. It operates major divisions including S&P Global Ratings, S&P Global Market Intelligence, S&P Global Commodity Insights, S&P Global Mobility, and S&P Dow Jones Indices.

The ICE BofA U.S. High Yield Index is an unmanaged index that tracks the performance of U.S. dollar denominated, below investment-grade rated corporate debt publicly issued in the U.S. domestic market.

The S&P 500 Growth measures constituents from the S&P 500 that are classified as growth stocks based on three factors: sales growth, the ratio of earnings change to price, and momentum.

The S&P 500 Value Index measures constituents from the S&P 500 that are classified as value stocks based on three factors: the ratios of book value, earnings and sales to price.

The S&P 500 Equal Weight Index is the equal-weight version of the widely regarded Standard & Poor’s 500 Index, which is generally considered representative of the U.S. large capitalization market. The index has the same constituents as the capitalization-weighted S&P 500, but each company in the index is allocated a fixed weight of 0.20% at each quarterly rebalancing.

The WCA Rising Dividend Custom Benchmark is a rules-based benchmark constructed by Washington Crossing Advisors to represent a universe of large capitalization U.S. companies that meet certain quality and dividend growth criteria, including proprietary screens for profitability, earnings consistency, and balance sheet strength, along with minimum market capitalization and dividend growth requirements. The benchmark is reconstituted and rebalanced quarterly and is intended to serve as a style-appropriate benchmark for the WCA Rising Dividend strategy.

The Washington Crossing Advisors’ High Quality Index and Low Quality Index are objective, quantitative measures designed to identify quality in the top 1,000 U.S. companies. Ranked by fundamental factors, WCA grades companies from “A” (top quintile) to “F” (bottom quintile). Factors include debt relative to equity, asset profitability, and consistency in performance. Companies with lower debt, higher profitability, and greater consistency earn higher grades. These indices are reconstituted annually and rebalanced daily. For informational purposes only, and WCA Quality Grade indices do not reflect the performance of any WCA investment strategy.

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The information contained herein has been prepared from sources believed to be reliable but is not guaranteed by us and is not a complete summary or statement of all available data, nor is it considered an offer to buy or sell any securities referred to herein. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. There is no guarantee that the figures or opinions forecast in this report will be realized or achieved. Employees of Stifel, Nicolaus & Company, Incorporated or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed within. Past performance is no guarantee of future results. Indices are unmanaged, and you cannot invest directly in an index.

Asset allocation and diversification do not ensure a profit and may not protect against loss. There are special considerations associated with international investing, including the risk of currency fluctuations and political and economic events. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments. Investing in emerging markets may involve greater risk and volatility than investing in more developed countries. Due to their narrow focus, sector-based investments typically exhibit greater volatility. Small-company stocks are typically more volatile and carry additional risks since smaller companies generally are not as well established as larger companies. Property values can fall due to environmental, economic, or other reasons, and changes in interest rates can negatively impact the performance of real estate companies. When investing in bonds, it is important to note that as interest rates rise, bond prices will fall. High-yield bonds have greater credit risk than higher-quality bonds. Bond laddering does not assure a profit or protect against loss in a declining market. The risk of loss in trading commodities and futures can be substantial. You should therefore carefully consider whether such trading is suitable for you in light of your financial condition. The high degree of leverage that is often obtainable in commodity trading can work against you as well as for you. The use of leverage can lead to large losses as well as gains. Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments.

All investments involve risk, including loss of principal, and there is no guarantee that investment objectives will be met. It is important to review your investment objectives, risk tolerance, and liquidity needs before choosing an investment style or manager. Equity investments are subject generally to market, market sector, market liquidity, issuer, and investment style risks, among other factors to varying degrees. Fixed Income investments are subject to market, market liquidity, issuer, investment style, interest rate, credit quality, and call risks, among other factors to varying degrees.

Beta is a measure of the volatility, or systematic risk, of a security or a portfolio relative to the market as a whole. A beta of one is considered as risky as the benchmark and is therefore likely to provide expected returns approximate to those of the benchmark during both up and down periods. A portfolio with a beta of two would move approximately twice as much as the benchmark.

Standard deviation is a measure of the volatility of a security’s or portfolio’s returns in relation to the mean return. The larger the standard deviation, the greater the volatility of return in relation to the mean return.

Changes in market conditions or a company’s financial condition may impact a company’s ability to continue to pay dividends, and companies may also choose to discontinue dividend payments

This commentary often expresses opinions about the direction of market, investment sector, and other trends. The opinions should not be considered predictions of future results. The information contained in this report is based on sources believed to be reliable, but is not guaranteed and not necessarily complete.

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