Lost decade continues as emerging market equities lag US counterparts

The beginning of the end of cheap money was heralded as the moment when emerging market stocks would reverse a decade spent in the shadows of their counterparts in developed countries.

It turns out to be anything but.

After a three-week rally in October that briefly sparked hopes for a comeback, the benchmark for the group has fallen, reaching a 20-year low against its main US counterpart. That provides early evidence that as global markets adjust to the idea of ​​less stimulus from central banks, including the Federal Reserve, emerging markets are failing to gain much traction.

It’s a well-known story. Despite faster growth and cheaper valuations, emerging market equities have lagged the US for most of the past 11 years. But as the Fed winding down loomed, money managers including Goldman Sachs Group Inc and Bank of America Corp saw a new commodity cycle and business growth usher in an era of primacy for them. Instead, what some investors have described as emerging markets’ “lost decade” only seems to be getting longer.

“U.S. stocks got more power than emerging-market stocks because they’re essentially a better story,” said Daniel Gerard, senior multi-asset strategist at State Street Global Markets in Boston. Investors will watch this week as reports of economic activity from China to Russia and Brazil bolster that story.

Fundamental mistake

The MSCI Emerging Markets Index is down about 2% this year, compared to a 25% rally in the S&P 500 Index. As a result, the ratio between the two indicators has fallen to its lowest level since December 2001. Although developing country stocks are 40% cheaper than their US counterparts, a poorer earnings outlook discourages investors from entering that discount.

“We remain cautious on emerging market equities and prefer to be overweight developed markets,” said Patrik Schowitz, a global multi-asset strategist at JPMorgan Asset Management in Hong Kong. The performance headwinds have resulted in earnings in emerging markets being much weaker than in developed markets.

Since October 2010, the S&P 500 is up nearly 300%, while emerging markets have added a paltry 14%. The latter also lagged behind Europe and Japan during this period. The market value of US equities has risen by $39 trillion, while all designated emerging markets combined have added less than $16 trillion.

Tighter monetary conditions could still lead to increased capital flight from the US, where the positioning has been ultra-long for years. Still, emerging markets remain too weak to capitalize on that vacuum as their relative growth advantage shrinks, investors say.

Emerging economies grew on average 2.4 percentage points faster than developed countries in the six years before Covid-19. That gap has narrowed to an estimated 1.2 percentage points this year as developing countries fail to match richer countries in providing fiscal and monetary support to their economies. The spread is not expected to widen again before 2023.

Central to all of this is China, which accounts for 42% of emerging markets by equity capitalization. Debt reduction and stricter regulations threaten to shift trend growth in the world’s second largest economy to less than 6% a year. President Xi Jinping’s “common prosperity” program also sees the country return to the communist principles of yesteryear.

Analysts are becoming skeptical about business performance in developing countries. Average 12-month earnings estimates for MSCI index members have stagnated in the second half, while they are up about 7.5% for the S&P 500.