Should long-term investors consider allocating more of their equity allocation to emerging markets now? Yes! The iShares Core MSCI Emerging Markets ETF (IEMG) currently trades just above its recent low of $51.25 made on June 27th, the lowest point in just about a year and a potentially attractive entry point. IEMG is the 2nd largest emerging markets ETF with $46 billion in AUM, providing high liquidity, and only charging a 0.14% internal expense ratio. IEMG is an attractive vehicle to gain exposure to emerging markets and currently has a twelve-month trailing yield of 2.71%. It is benchmarked to the MSCI Emerging Markets Investable Market Index (IMI) which has large, mid, and small capitalization representation across 24 emerging market countries. The benchmark index has 2,876 constituents while covering approximately 99% of the free float-adjusted market capitalization in each of these countries. IEMG is composed of 1,916 constituents.
Emerging markets are diverse, yet dominated by a few large countries, as shown in chart 1. China represents over 38% of the market capitalization of emerging markets, with India and South Korea coming in second and third. The statistics of the companies comprising the constituents of the MSCI Emerging Markets IMI are varied. The largest company in the index has a market capitalization of $286.1 Billion and the smallest is $15 Million. The average market capitalization of a company in the index is $2.1 Billion while the median company size is $449.2 Million.
With 2,876 constituent stocks, the MSCI Emerging Markets IMI is much broader than the S&P 500 Index, representing large cap U.S. equity markets, which has approximately 500 constituents. The largest company in the S&P 500 Index is $909.8 Billion and the smallest company is $3.2 Billion. The average market capitalization of a company in the index is $47.8 Billion while the median company size $20.5 Billion.
The earnings growth prospects for the MSCI Emerging Markets IMI compare favorably with those of the S&P 500 Index. On a 5-year forward basis, earnings estimates are roughly 17.8% annualized for emerging versus 11.9% annualized for U.S. domestic, per Bloomberg consensus estimates. On a long-term basis earnings growth for emerging markets should be around 10+% and long-term earnings growth for the S&P 500 should be around 6%.
But earnings in emerging markets can be quite volatile. Chart 2 shows that for the last six years the Year-Over-Year earnings growth is virtually zero, despite the strong longer-term historical average.
A case in point is 2014 and 2015, shown in chart 2, where year-over-year earnings growth turned negative primarily due to collapsing oil prices and a soaring dollar, as shown in Charts 3 and 4, respectively. This just emphasizes that an investment in emerging markets needs to be long-term and that an investor needs to have a higher risk tolerance and an ability to ride out the greater volatility inherent in the emerging equity markets. The long-term standard deviation of the MSCI Emerging Markets Index is 22%, while the S&P 500 Index has a long-term standard deviation of 15%.
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U.S. Dollar Index – Cash SettleIn addition to earnings growth prospects, there are many metrics by which to measure whether a market is over-valued, under-valued, or at fair value. One long-term valuation indicator, the Stock Market Capitalization to GDP ratio, gained popularity after the Sage of Omaha, Warren Buffet, described it as “probably the best single measure for where valuations stand at any given moment.”
Once you calculate this ratio, how do you read it? Generally, the ratio can be interpreted using the below breakpoints:
| Undervalued | Modestly Undervalued | Fairly Valued | Modestly Overvalued | Overvalued |
| < 50% | 50% – 75% | 75% – 90% | 90% – 115% | >115% |
However, in recent years determining what percentage level is an accurate representation has become a hotly debated topic as the ratios have been trending higher over a long period of time.
Global Market Capitalization
So where does this measure currently stand? First, let’s look at global stock market capitalization. If you calculate the value of all stocks, in all companies, in all countries, globally you get the unfiltered and unscreened market cap of the world. In Table 1 we can see the total global stock market capitalization for all the countries in the world that have equity markets. As shown both in Table 1 and chart 5, the “All-In” number for global stock market capitalization is $80.9 trillion as of March 31, 2018.
Global GDP
Now, let’s look at global GDP. We sourced GDP as of December 31, 2017 for all of the world’s countries from the International Monetary Fund (IMF). Ideally, we would like to have the data points for Global Market Cap and Global GDP for the same time period, but GDP is lagged by 1 quarter, as GDP takes longer to calculate and compile than do stock market capitalizations. Global GDP these days grows at about 4% per year, or 1% per quarter, so to normalize and make the measures for both a coincident time, we could just increase the GDP figure by 1%, or we could measure the Global Market Cap as of one quarter ago. Let’s use the lagging by 1 quarter GDP and the current Market Cap for this discussion.
We can see a graphic of total global GDP in Chart 6. The global stock market capitalization of $80.9 trillion, shown in chart 5, is very close to the $80.0 trillion of global GDP, shown in chart 6. The stock market capitalization to GDP ratio for the world is $80.9 trillion/$80.0 trillion or 101.1%, falling in the modestly overvalued range. But if we look at the developed markets ratio versus the emerging markets ratio we can see a dichotomy. Developed markets have stock market capitalization to GDP ratio of 133.9%, derived by $60.8 trillion stock market capitalization/$45.4 trillion GDP. Meanwhile, emerging markets have a stock market capitalization to GDP ratio of 58.1%, being modestly undervalued, but close to undervalued (50%).
There are arguments that this dichotomy is justified. Developed markets are less politically volatile, have more stable legal systems, they have better stock market liquidity and depth, possess less currency risks, and generally have less unknown variables to deal with. Furthermore, the average market cap for companies in the MSCI Emerging Market IMI is around $2.1 Billion, compared to $47.8 Billion for the average S&P 500 constituent, so there is inherent risk in emerging markets due to the size factor. Therefore, some say that the U.S. & international developed markets deserve higher valuations versus the emerging markets.
Perhaps the most striking insight of this exercise is that while emerging market stock market capitalizations only make up 25% of the global total, emerging market GDP accounts for roughly 43% of the global total. Most investors have been conditioned to think of emerging markets as a much smaller slice of both the global stock value (market capitalization) and the global economy.
The bias towards developed over emerging is clearly seen in how MSCI measures the global markets when constructing the MSCI All Country World Index (ACWI), considered by many to be the definitive take on the world stock market composition. In the ACWI, emerging markets comprise roughly only 10% of the allocation, as opposed to the 25% slice in Chart 5 showing global stock market capitalizations.
MSCI Index Methodology
Below we get into the details of how MSCI narrows the emerging markets universe from the broadest global equity capitalization, which we derived from Bloomberg data and is shown in Chart 5. In the broadest global equity capitalization emerging has a 25% weight but MSCI filters it down to the 10% weight in the MSCI ACWI Index. If you wish to continue to focus on the investment case for emerging markets, please skip ahead to the “Investment Case Resumed” section.
MSCI constructs its indices using a proprietary filtering methodology, which is complex and not fully disclosed. We have come up with an approximation of MSCI’s process which is distilled into two main components – a curated list of countries, and modified market capitalizations based on publicly available shares. The countries that MSCI lists as ACWI components are shown in Table 2. MSCI clearly does not include every world country when it constructs its indices. Instead, MSCI chooses which countries it believes deserve inclusion based upon a variety of proprietary factors. The MSCI ACWI Index (ACWI), which contains 2,781 constituent companies representing large and mid-capitalization stocks across 23 developed and 24 emerging markets, covers 85% of the global investable equity opportunity set and is comprised of component indices. The emerging component index of the ACWI is the MSCI Emerging Markets Index which captures large and mid-capitalization across 24 emerging market countries, with 1,138 constituent companies and covers approximately 85% of the free float-adjusted market capitalization of these emerging countries. This MSCI Emerging Index, is separate and distinct from the MSCI Emerging IMI, discussed earlier, which has large, mid, and small capitalization representation across 24 emerging market countries. The MSCI Emerging IMI has 2,876 constituents and covers approximately 99% of the free float-adjusted market capitalization in each of those emerging countries
We performed an analysis to approximate how MSCI culls the global stock market capitalization as it constructs the ACWI, as shown in Table 1, in the column titled “ACWI MCAP Country Filter”. We took global stock market capitalization, country by country, and excluding the same countries that MSCI does when constructing the ACWI.
The ACWI MCAP Country Filter column whittled the broadest view of the world down from 85 countries to 47, eliminating 38 from the Total Global MCAP column, but we only show the top 25 countries to conserve space. Out of the 38 countries eliminated by MSCI, 33 are emerging countries and 5 are developed. Also, the market capitalization in emerging is reduced from $20.1 trillion down to $18.9 trillion, as seen in Chart 7. Chart 7 shows our adjustment for MSCI’s country filtering. While it does have some impact, the percentage slice of the pie for emerging markets drops only slightly from 24.9% to 23.7% after accounting for MSCI’s country selections.To get closer to the MSCI ACWI index, which consists of what MSCI considers the “investable universe”, we execute the second MSCI filtering process to account for MSCI’s use of “Free Float” company market capitalization. Free Float market capitalization attempts to identify the portion of equity shares that are readily available to the public market.
Equity shares may be heavily controlled by one or a small knit group of owners’; such as founders, officers, or sometimes states, making the shares unavailable to public investors. China has particularly high levels of government ownership of corporations, making the Free Float market capitalization there much lower than developed nations. This is one of the major reasons why the emerging market portion drops off much more in this phase of filtering. The two mainland Chinese stock exchanges, in Shanghai and Shenzhen, are largely inaccessible to foreign investors despite being the 5th and 8th largest exchanges in the world, respectively.
The Free Float market capitalization adjustment, shown in Table 1, in the column titled ACWI MCAP Free Float Filter, has a much greater impact on emerging markets weight in the global stock market capitalization than does the initial MSCI country adjustment. The percentage slice of the pie, shown in Chart 8, for emerging markets drops from 23.7% down to about 15.2% after accounting for MSCI’s Free Float company market capitalization adjustment. This still leaves the emerging markets weighting roughly 5% higher than ACWI’s 10% emerging markets weighting. This is attributable to the other additional “proprietary” grooming MSCI performs in constructing their index. MSCI applies a complex grooming methodology with a multitude of rules for including/excluding securities to get to their final index composition. But despite the limitations due to the proprietary nature of MSCI’s calculation methodology, we have given a good accounting for the reduction from a broad 25% emerging market weight to the 10% weight in the ACWI.
This analysis raises a question – should we really be looking at the global markets through this prism, slanted so heavily towards developed markets? Does doing so leave investors underexposed as to the true opportunity to be found in emerging markets?
MSCI itself is beginning to change a bit, and as of the end of May, it added 234 Chinese mainland listed stocks that had previously been excluded. MSCI will be adjusting the market cap of these stocks by what it calls its “Foreign Inclusion Factor”, giving them an aggregate weight within the MSCI Emerging Market Index of just 0.39%. Given emerging markets 10% ACWI weighting this equates to just 0.039% of the ACWI. So, while the effect is negligible, MSCI considers this a first step towards expanding its indices to cover more Chinese mainland “A-Shares” from the Shanghai and Shenzhen exchanges.
U.S.-China trade relations have been dominating headlines recently, and a major goal of these often-contentious talks is getting China to open its mainland commerce markets to foreign investors. While it remains to be seen if President Trump will strike a deal or strike out, it seems inevitable that China will eventually seek a larger role as a global superpower, and foreign investment will no doubt be critical to these efforts. We see this trend continuing, as other emerging markets such as India, with the world’s 11th largest exchange, also take a more prominent role in the global economy.
Investment Case Resumed
The demographics shown in Chart 9 also suggest an immense opportunity in emerging markets. As of 2017, emerging markets were home to 87% of the world’s population, with estimates of 95% by 2034. Furthermore, while most developed nations are aging, roughly 90% of the world’s population under 30 years of age live in emerging markets. Not only do emerging markets have the labor pool advantage, they are also poised to capitalize on productivity growth thanks to advancing technology. Access to the internet is becoming exponentially more common in emerging markets, while smartphone ownership has grown from a median of 21% in 2013 to 37% in 2015, according to the Pew Research Center.
In addition to the other compelling reasons we have presented for owning more of emerging markets, undervaluation is another attractive reason to consider.
The S&P 500 index has a trailing 12-month Price Earnings (PE) ratio of slightly over 21 whereas the MSCI Emerging Markets index has a trailing 12-month PE ratio near 13. In Chart 10 we can see that the MSCI Emerging Market index PE ratio has become increasingly cheap relative to the S&P 500 index PE ratio. The spread between those two PE ratios represents the relative cheapness of emerging markets versus domestic U.S. markets, and it shows the PE Spread line at its greatest difference since 2010.
Building on the theme of undervaluation, the Oppenheimer 2018 Mid-Year Outlook makes a strong case for the undervaluation of emerging markets versus developed markets.
Chart 11, from the Outlook piece, shows the comparison of Price-To-Sales Ratio of MSCI Emerging Markets Index versus the MSCI World Index indicating that the ratio is below average, and undervalued. The gray shaded areas in the charts indicate economic contractions in emerging markets. Chart 12, which also appeared in the Oppenheimer 2018 Mid-Year Outlook, shows the Emerging Markets Composite Purchasing Managers Index (PMI) on the left axis sitting above 50, indicating expansion. Chart 12 also shows the MSCI Emerging Market Index (scaled on the right axis) with a 0.78 correlation to the PMI, suggesting that emerging markets will continue to rise along with the PMI. These two charts help to confirm the strong case for emerging markets.
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Another metric to consider when comparing emerging and developed markets is the forecast for future GDP growth. According to the data released by the International Monetary Fund (IMF) in April of 2018, the annual growth rate for emerging markets over the next 5 years will remain at a high level, while the growth rate of GDP for the developed region of the world will be declining, as shown in Chart 13. In 2018, the emerging market GDP growth rate forecast is projected to be twice that of the developed region, and three times by 2023. This is a very compelling reason to take a harder look at the emerging region of the world, and position portfolios for this coming shift.
The Federal Reserve’s drive to higher interest rates has played a role in making emerging market valuations attractive by helping to boost U.S. dollar and possibly, in the short-run, hurting emerging markets. The concern is that up-and-coming economies will be limited by higher American borrowing costs and may experience collateral economic damage from trade tensions. We believe that U.S. interest rates are not going to rise rapidly, with investors beginning to settle on a targeted equilibrium point for interest rates – probably not much more than a 2.75% Fed Funds rate – creating an environment for emerging market equities to appreciate.
As can be seen in Chart 14, the recent emerging markets pull-back is to a price seen 11 years ago. After breaking out above the 2007 high, emerging markets are now testing the support of the 2007 peak, which had been a resistance level for 10 years. Chart 15 provides a shorter-term view, including intermediate and long-term trendlines. The MSCI Emerging Market ETF (EEM) is displayed in Chart 14 and 15 because it has longer price history than the recommended IEMG ETF mentioned on the first page of this piece.
Conclusion
When taking all these factors into consideration, the question should be asked – are MSCI Indices, and portfolio managers generally, allocating enough to give proper weight to emerging markets in the world portfolio? Are emerging market indices and particularly the IEMG ETF, at a potentially profitable entry point now? For long-term investors who can tolerate the volatility, now is the time to consider giving an undervalued portion of the global markets, emerging market equities, a more prominent place in your portfolio.
