In 2017, emerging market stocks advanced by more than 34%. Conventional wisdom was quick to credit the weak U.S. dollar and accommodative monetary policy, not to mention a long-awaited bounce back after three weak years from 2013 to 2015. While these factors certainly contributed to 2017's performance, that conventional wisdom overlooks several secular trends — though still early — that are far more material to the longer-term prospects of emerging market equities.
In hindsight, it is generally easy to identify the tides of history that have altered not only the investment landscape but also the passage of civilization at large. It was the dominance of the Royal Navy that cleared a path for overseas trade, securing Britain's economic hegemony after the Napoleonic wars. World War II mobilized the United States' economy and manufacturing base, while positioning the dollar to become the world's reserve currency. The baby boom that followed drove unprecedented growth and, since 1946, has translated into a roughly 11% annualized return in the S&P 500.
It remains to be seen how the current global power structure will resettle after the U.K.'s exit from the European Union and as President Donald Trump's "America First" agenda progresses. What is becoming clear, however, is that the demographics of aging baby boomers, coupled with below-replacement birth rates in Europe and Japan, mean both domestic and international developed markets will be hard pressed to match their historical growth in the next decades. That leaves emerging markets, with rapidly growing and optimistic middle classes, as a potential anchor for institutional investors seeking returns in line with past eras. Moreover, an extended technology tailwind will overwhelmingly benefit developing markets as global connectivity accelerates all trends, both good and bad.
Much already has been made about the likelihood for decelerating growth in the U.S. and other developed markets. This is primarily a demographic story as the baby boomer generation in the U.S. exits the workforce and as the gap widens between rich and poor, creating new impediments to transitional growth. Japan, after two decades of deflation and with minimal consumption, can be viewed as the canary in the coal mine for what awaits other developed markets with aging populations. That is why many believe U.S. equity returns over the next two decades might struggle to achieve even 6.5% a year.
Emerging market stocks, in stark contrast, are expected by many long-term forecasters to return significantly more than U.S. stocks — an assumption that captures the unprecedented rise of an emerging global middle class. A recent study from the Brookings Institution highlighted that in the next two to three years, for the first time ever, a majority of the world's population will live in either middle- or upper-class households. Of the new entrants, the report estimated that 88% will live in Asia, representing a new population of consumers who will be a generation younger than the baby boomers, arrive with little if any existing debt and bring an extremely optimistic outlook that influences everything from consumption patterns to investments.
But shifting demographics are just one component. Another factor is the technology transfer taking place, in which emerging market economies benefit from the extraordinary investment in research and development and innovation in developed markets over the past century.
The spread of technology alone can dramatically transform maturing economies. The Organization for Economic Cooperation and Development has estimated a 10% increase in broadband penetration translates into a 90-basis-point to 150-basis-point bump in per capita GDP growth. A country such as Malaysia, for instance, has been able to transform its economy from one largely driven by low-cost manufacturing to one in which digital and tech-enabled services now account for nearly a fifth of its total gross domestic product.
The ongoing transfer of technology could threaten many of the more traditional bellwether names in developed markets. Take Boeing Co., or Airbus SE. The market for jet manufacturers hasn't seen a new entrant in nearly 40 years, yet the Chinese civil aviation company COMAC successfully completed its inaugural test flight for its C919 jetliner in May 2017. The 160-seat, single-aisle aircraft is being built using component systems and parts from international suppliers, such as Rockwell Collins and Honeywell. In October, at the 19th National Congress of the Communist Party of China, General Secretary Xi Jinping even cited the C919 test flight as evidence of the country's progress in ascending the global value chain.
Where these compelling secular trends converge is that China and other emerging market economies are taking on supply-side structural reforms, centered on innovation, to meet the demand that will arise from within their own borders. Boeing has forecast that over the next 20 years, China will need more than 7,200 new planes, worth more than $1 trillion, just to accommodate air travel within the country.
Even as emerging markets are primed for rapid expansion over the next 10 to 15 years, the caveat is that emerging market equities won't necessarily shake their reputation for volatility. Economic hiccups, geopolitical events or even renewed strength in the dollar could present temporary headwinds that are neither predictable nor always clear. But the force of an ascendant middle class, aided by a technological tailwind, should drive outperformance in emerging market stocks for the foreseeable future.
