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The Coming Shift in Emerging Markets

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Over the last two decades, the emerging markets (EM) story has focused on unprecedented growth in China. That nation built a strong export-oriented manufacturing base and relocated some 400 million rural Chinese farm laborers into cities.

Today the EM story is moving beyond China. Due to dramatic wage growth, China can no longer be the low-cost producer for the world. Chinese hourly wages tripled in the last 10 years, taking them higher than most all of their Latin American and Asian emerging market counterparts. As a result, labor-intensive manufacturing has been moving out of China and into other EM countries, creating an economic spillover effect. We are now seeing a replay of the China growth story playing out in other emerging markets as the new factory jobs transition millions out of poverty and into the middle class.

(Related: Emerging Markets: Opportunities Abound, but Beware the Index)

The Brookings Institution estimates that globally, 140 million people are moving into the middle class every year, a number it anticipates to grow. Global middle-class spending is expected to increase by $10 trillion between 2015 and 2022, with approximately 80 percent of that coming from Asian markets.

By harnessing this burgeoning middle class, we believe U.S. investors can benefit from diversifying into emerging markets. EM economies are much more accommodative to growth, valuations are reasonable — if not cheap — and relative earnings growth looks attractive. On a simple price-to-earnings Ratio (P/E) basis, the MSCI Emerging Markets (EM) Index traded at a 30% discount to the S&P 500, despite much higher earnings growth prospects relative to the S&P 500, according to data through the end of September.

Earnings for the MSCI EM Index — a free-float-adjusted market capitalization index designed to measure equity market performance of EM — grew 18% in 2016 and are forecast to grow 30% this year, and 17% in 2018, based on Bloomberg bottom-up consensus estimates. By contrast, with S&P 500 companies near all-time high profit margins, and a tight US labor market, we see S&P 500 earnings growth as more compromised for the remainder of this cycle.

Source: Bloomberg, Bloomberg Consensus Estimates, MSCI

While developed markets are hamstrung by aging populations, slowing labor force growth and growing entitlement obligations, in emerging markets we see a very different picture. Ninety percent of the global population under age 30 reside in emerging economies; these countries already represent a large portion of the world’s labor force and are projected to become even larger.

The changing profile of emerging markets is not fully reflected in the MSCI Emerging Markets Index. It still has strong representation from the highly cyclical commodity and financial sectors, comprising 38% of the index. These sectors benefited from China’s past growth, but are less likely to capture the growth in middle class spending.

In addition, the middle-class growth story is not uniform. While the middle class in India is expected to grow more than three-fold by 2025 as a result of economic reform initiatives, both South Korea and Russia have aging populations much like the developed world. And countries such as Turkey and Greece have structural and regulatory hurdles that impede middle-class expansion.

In aiming to reduce the volatility that accompanies EM investing, we suggest one consider an active approach. Specifically, one that seeks to avoid the cyclical commodity and financial sectors (and countries) and focus on sectors (and countries) that accompany growing prosperity, such as internet-based retail, mobile technology and health care.

* MSCI provides per share data on an annualized basis. EPS is calculated using net earnings and number of shares in which all classes (listed and unlisted) of equity are aggregated. The total shares outstanding for the latest period is used for per share data calculations. Using historical and forecasted per share data, MSCI calculates index ratios.


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