I was recently attending a nonprofit’s investment committee meeting when our consultant pointed out how poorly the emerging-markets (EM) equity asset class had performed over the past five years. Sure, I knew it had been a laggard, but for U.S. dollar–based investors, the MSCI Emerging Markets Index has been the performance caboose of the global capital markets, with just a 2.1 percent annualized return over the five years ended December 31, 2014. And if that were not bad enough, I was reminded that EM public equities’ performance was 80 percent correlated to the Standard & Poor’s 500, with annualized volatility of 19 percent.
For an asset class that is supposed to help sophisticated investors gain access to the world’s fast-growing middle class amid a period of excessive leverage and demographic headwinds in the developed markets, EM public equity performance results have, to say the least, been quite disappointing in recent years. This underperformance has been true even for local-currency investors, as EM large-cap stocks, particularly in Latin America, have underperformed badly in many instances.
Against this backdrop my KKR global macro and asset allocation colleagues and I spent some time addressing the questions of not only what has been ailing emerging-markets public equities but where we go from here in terms of future allocations to the asset class. Our primary conclusions are as follows:
A significant portion of the underperformance of EM equities has been linked to multiple contractions in the public markets. All told, EM equity multiples have contracted, on average, about 26 percent over the past five years. Frontier markets, which represent even more growth and less maturity than traditional EM markets, also experienced significant multiple contractions, on an average of 31 percent during the same period.
Another major detractor from EM public equity performance for U.S. dollar investors has been currency depreciation. We estimate that currency depreciation alone has reduced MSCI EM Index returns for a U.S. dollar–based investor to 11 percent from 29 percent, a full 62 percent haircut. The index’s trailing five-year performance compound annual growth rate (CAGR) was just 2.1 percent per year in U.S. dollars, versus 5.2 percent per year in local terms. We envision more currency headwinds ahead for EM equities, particularly as the Federal Reserve begins its tightening campaign in the months ahead.
Despite gross domestic product growth that is notably faster than in the developed markets, earnings in the EM world have lagged badly. Two key issues are margin degradation and equity dilution, which have impeded growth and returns. Since 2010, earnings per share in EM public equities have stayed flat in local currency terms and have actually been negative in U.S. dollar terms.
Lastly, EM country and regional indexes often have major skews that can, at times, negatively affect performance. As such, an investor may buy an index to gain exposure to a thoughtful macro theme such as increasing consumption per capita or above-average GDP growth, but end up owning a concentrated index levered to a particular product cycle, commodity or state-owned enterprise. With shares of a large-cap company like Petrobras declining by 60.2 percent (and 77.6 percent in U.S. dollars) over the past five years, this issue has clearly affected Latin America’s recent performance. Our research shows concentrated country indexes have returned cumulatively just 12 percent during the past five years, compared with 44 percent for the remaining EM indexes.
Although the sluggish investment performance of EM public equities might, on the surface, suggest that investors avoid the asset class in its entirety, that conclusion is not one we champion. Rather, our work suggests that EM equities can be owned in size but generally will be successful only when five key rules of the road are followed.
Our rules are:
1. Buy when return on equity is stable or rising. Slowing nominal GDP growth is a headwind to operating leverage and asset turns.
2. Valuation: It’s not different this time. Significant multiple contractions have occurred since 2010, but it’s still not at close-your-eyes-and-buy levels.
3. EM foreign exchange follows EM equities. Forex is likely to remain a headwind for U.S. dollar– or other hard-currency-denominated investors.
4. Commodities correlation in EM is high. The S&P GSCI index of global commodities has fallen considerably led by oil, but supply and demand remain too loose to call a bottom.
5. Momentum matters in EM equities. EM’s relative momentum remains slightly negative (–8 basis points year-on-year at the end of April) but has clearly perked up in recent months (5.3 percent year to date). We are watching for signs of a definitive turn.
So what are our rules of the road suggesting in terms of EM equity allocations at the moment? Despite significant underperformance of late, our research shows that now is not yet the time to make the big EM cycle-turning equity bet, particularly given our ongoing concern about EM currencies.
Rather, we prefer increasing exposure through selectivity, following the message we laid out in our 2015 Outlook piece (see “Getting Closer to Home,” January 2015). Most important, we retain a bias within EM for Asia over Latin America. To date in 2015, on a total return basis, EM Asia has already outperformed EM Latin America by nearly four percent (11.7 percent versus 7.8 percent) in local terms. Since 2009, however, the gap between the two regions has been massive, with EM Asia returning nearly 150 percent versus 85 percent for EM Latin America in local terms. Within Asia we still favor cyclicals in India and laggard, lower-beta and restructuring names in China.
We also continue to advocate for interesting one-off EM public equity situations in other markets. For example, after the precipitous fall in oil prices, Nigerian banks now look compelling at less than half of book value, while certain real estate plays in Mexico, particularly those with development skills (versus serial acquirers), appear attractive. Finally, with the recent pullback in India, we would be adding to positions there.
Beyond beginning to scale into public EM equities, we believe that nontraditional EM structures, including distressed, Asian private equity, real estate and parts of credit may be a more compelling way to take advantage of the current dislocation occurring across EM, particularly as China slows. Key to our thinking is that these vehicles may represent more targeted approaches to capturing a specific theme or macro trend. In the cases of credit and real estate, high nominal rates in many EM countries often allow investors to earn ongoing coupons that dwarf what is available in the public equity markets, while still being higher up in the capital structure. This view toward using a more targeted and nontraditional approach is not new for us. However, it has served us well during our time as a global asset allocator, and we continue to advocate it, particularly for institutional accounts with a heavy international focus.
Henry McVey is the head of global macro and asset allocation at KKR in New York.
