Here we are again. Poor recent performance from emerging markets equities, and the entire asset class is under review. We heard the negativity in early 2009, just prior to that year's 78% jump. We heard it at the end of 2011, just before 2012 saw emerging markets outpace the developed world en route to another double-digit return.
The emerging markets asset class is not a market timer's game. Market timing is expensive. It's risky. And it's not necessary. For the 10 years ended Dec. 31, the MSCI broad emerging markets index saw an annualized return of 11.2%, more than 4% per year higher than developed markets. That 10-year period saw some white-knuckle ups and downs. Get even one of them wrong, and returns can evaporate. Steady exposure, on the other hand, was well rewarded over this period.
We believe the key to success in emerging markets is disciplined, consistent exposure combined with active management. Whatever the short-term outlook for the asset class, investors have two very attractive opportunities — the ability to participate in the long-term growth of what is still the world's most dynamic economic sector, and the potential to benefit from active stock and country selection in an extremely diverse asset class.
A clear and objective assessment of emerging markets right now, based on key attributes such as momentum, valuation and growth, presents a neutral outlook. Momentum is increasingly negative. Value measures are looking better after last year's historically large lag. Earnings are growing less quickly than in the recent past, though still at a higher rate than developed market counterparts.
This makes for a potentially good entry point as we look to a year where the environment could shift more favorably. In our view, the impact of Fed policy on markets is likely to be more muted than in the past. Tapering is universally expected, and is likely to be both cautious and gradual. A bigger issue is the perceptions of positive policy change in some of the more high-profile emerging markets, such as China, Brazil and India. China policymakers seem to be saying some of the right things about reforming the economy and strengthening the financial system while trying to reduce risks from shadow banking, but investors will want to see more concrete evidence of success. Brazil must address binding economic bottlenecks such as infrastructure constraints and the crowding-out of private finance. India also has much to do, and upcoming elections are likely to have a significant impact on the prospects for more essential reforms.
It isn't helpful for emerging markets sentiment to have major ongoing problems that cast doubt on governance at the national policy-setting level in countries such as Turkey and Thailand. These are not large countries, but some resolution of the issues here — which we would expect over the coming year — could be disproportionately positive. There are already some bright spots for policy change beyond the BRICs that could benefit future equity returns, such as Mexico.
The biggest positive that we would see for emerging markets over the coming year is a better prospect for the world economy as a whole. A strengthening U.S. economy appears likely, with reduced monetary and fiscal risks. China (the second largest economy after the U.S.) might not hit 7.5% real growth, but seems unlikely to crash. Meanwhile, Japan is seeing some benefits from recent economic policy initiatives. Growth in these key economies will help to improve growth in emerging markets through trade links and should improve sentiment and funds flows as we go through the year.
As global investors look for relative opportunities among equities this year, emerging markets are likely to come back on radar screens. Valuation multiples are attractive, with emerging markets price-earnings ratios significantly lower than those of developed markets on average (12.1 vs. 17.9), while emerging markets return on equity is somewhat higher (12.7% vs. 12%). Stabilization of currencies without the sharp drops vs. the U.S. dollar and euro for many emerging markets currencies over the last year should help sentiment, as well as obviously realized dollar-stated returns.
And this is just at the index level. There is much an investor can do beyond sitting tight through the rough patches in a long-term emerging markets allocation. This is an asset class that calls for active investing. Active approaches, especially those that can gain exposure to small-cap stocks and frontier markets, have much greater scope to overcome the current emerging market malaise. Our current country forecast for emerging markets data shows considerable variation from top to bottom, indicating strong potential for active returns from stock selection and country allocation effects. Among the most attractive areas in our framework currently are Poland in emerging markets and Pakistan in frontier. The energy and telecoms sectors are offering some attractively valued companies with strong growth potential.
Acadian has tracked hundreds of stock and country characteristics over many decades to analyze their relationships to subsequent returns. If markets are completely efficient, we would expect to find only random noise in stock prices, with low predictive power. Instead, there is strong evidence of persistent mispricings. These are related both to investor psychology — perceptions of risk, misapplication of information — and real structural barriers such as benchmark orientation and institutionally imposed constraints. Perhaps not surprisingly, our work has shown emerging markets to be one of the least efficient areas of the global investing universe.
Given the broad evidence supporting long-term economic growth in emerging markets, the rich potential for active return, and the major risks associated with timing returns in the emerging markets asset class, the way forward seems very clear. As a former naval officer, I am tempted to use familiar metaphors of staying the course, steady as she goes. It may not be too steady in the short term but if the goal is to maximize long-term equity returns, we believe emerging markets remain an essential sea to navigate.
Ronald D. Frashure is chairman, Acadian Asset Management LLC, Boston.
