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FEBRUARY 2016
INVESTMENT MANAGEMENT
Investment Focus
Why Growth Matters in EM, Now More Than EverExecutive SummaryThe global slowdown has not been kind to emerging markets (EM). Though growth is slowing everywhere, it has slowed more sharply in EM economies than in developed market (DM) economies. Emerging economies are still growing faster, but the growth differential1 has been narrowing and market performance has suffered. Perhaps nothing personifies the negative sentiment towards the asset class more than the recent closing of the “BRIC Fund,” which flourished during the EM bull-run that ended years ago.2
Some investors are questioning the EM equity asset class as a whole. Yet such extremes in negative sentiment often mark a turning point in an asset class,3 and we actually believe that the adjustment in EM could be nearing the final innings. This paper employs our research to answer three of the most pressing investor questions regarding when and how to allocate money to EM. Our answers, in brief:1. When do potential opportunities exist in the EM market? When the relative
real GDP growth differential between EM and DM is rising. EMs tend to grow faster than DMs at an absolute level, but potential opportunities arise in emerging markets when their GDP growth rates are increasing by more than those in developed markets (or falling by less). For example, EM outgained the MSCI World Index by
1 Throughout this paper we will refer to the “growth differential,” which is simply the difference between the EM aggregate real GDP growth rate and the DM aggregate. For instance, if EM growth is 5% and DM growth is 2% then the differential will be 3%.2 “Goldman Closes BRIC Fund.” The Wall Street Journal. November 9, 2015. 3 Forthcoming research by MSIM Emerging Markets Equity team. See also: “Breakout Nations” by Ruchir Sharma. Chapter 12, pg. 207 and “How Narendra Modi won by losing ‘Person of the Year,’” by Ruchir Sharma in The Times of India, December 17, 2014.
AUTHORS
JITANIA KANDHARIExecutive DirectorMorgan Stanley Investment Management
STEVEN QUATTRYVice PresidentMorgan Stanley Investment Management
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INVESTMENT FOCUS
165% from 2002-2009 as the growth differential was rising, however since then, emerging market stocks, represented by the MSCI EM Index, have underperformed the World Index by 44% as EM growth has slowed relative to DM.4
2. Does growth matter for country allocation in EM? Yes. There is a camp that argues that growth does not matter but bases this conclusion on growth and returns over periods as long as a century. Our research focuses on periods that correspond more closely to investor holding periods, three to five years, and comes to a different conclusion. We find that countries with higher real GDP growth (top quintile) outperform the MSCI EM index by an average rate of 4.1% a year, while countries with lower GDP growth (bottom quintile) underperform by 0.7% a year. The same holds true in examining Frontier Markets.5 Identifying growth inflection points is also of value: countries with the largest acceleration in GDP growth outperform the index by an average annualized rate of 9.6%, while those with the largest deceleration in GDP growth underperform the index by 4.4%, for a spread of 14.0% annualized.6 Moreover, in periods like the present, when there is only a small GDP growth differential between EM and DM, the variation of returns between the equity markets of different EM countries is significantly higher than normal. In other words, growth is particularly important to EM country allocation and alpha generation in the current environment.
3. Does valuation matter for country allocation in EM? Surprisingly, no. Conventional valuation metrics like price-to-earnings ratio or price-to-book7 rarely contain valuable information regarding future equity returns in EM. Value as a strategy works generally when valuation spreads8 are elevated relative to the long term average (one standard deviation). We believe that valuations opportunities could eventually arise in
EM, but they are very rare and tend to occur during crises.9 At present, although spreads are elevated at 0.65 standard deviations, we think that they do not yet appear extreme.10 On the other hand, we find that currency valuation metrics contain valuable information pertaining to the country allocation decision in EM equities.
Applying our findings to the more recent post-crisis period (2009 to 2015), we find that high growth, high change in growth, expensive equity markets and cheap currencies all outperformed the EM index. Moreover, the fastest growing EMs outperformed the lowest growing EMs by 9.3% per year on average, while the countries with the largest growth ac-celerations outperformed those with the lowest by 7.6% a year. Expensive equity markets outperformed cheap markets by 4.6% a year, and countries with cheap currencies outperformed those with expensive currencies by 2.6% a year on average.
When does EM appear attractive?The past few years have proved challenging for investors in the EM equity asset class, and sentiment is fairly depressed at the moment. However, we would caution against extrapolating this negativity into the future. This is not to say that EM equity headwinds are over, however, we believe the adjustments needed are nearing completion, leading us to ask when is it time to buy.
We believe that the key driver of EM performance relative to developed markets is the GDP growth differential. Our analysis suggests that the best opportunities in EM stocks exist when EM GDP growth is increasing relative to DM GDP growth, as this has historically coincided with EM bull markets. Bear markets such as the past few years have historically coincided with periods when EM growth is decreasing relative to DM. In other words, it is not enough for EM GDP growth to be higher than DM GDP growth, because that is nearly always the case. Similarly, in order to remain negative on the EM asset class relative to DM, one has to expect the growth differential to continue to decrease, not simply stabilize. In the next section we briefly discuss the past, present, and future outlooks for the EM-DM growth differential, arguing for stabilization in the next 12 to 18 months and setting the stage for the next phase of an increasing differential.
4 Source: Factset. Data as of December 31, 2015. EM stocks/index throughout this paper refers to the MSCI EM Index, while DM/developed market refers to the MSCI World Index.5 We have replicated this study for MSCI Frontier Markets which has considerably less history, with data starting in 2002. Nonetheless, our findings for Frontier Markets are very similar: high growth outperforms low growth by a considerable spread. There were a few nuanced differences regarding the magnitude of returns for other factors, but broadly the findings were the same. 6 We have replicated this study for MSCI Frontier Markets which has considerably less history, with data starting in 2002. Nonetheless, our findings for Frontier Markets are very similar: high growth outperforms low growth by a considerable spread. There were a few nuanced differences regarding the magnitude of returns for other factors, but broadly the findings were the same. Findings are available upon request.7 Price-to-book is defined as the price of a stock or index divided by the book value per share. Similarly, price-to-earnings is defined as the price divided by the earnings per share. 8 Defined as the difference in valuation between cheapest and most expensive quintile of the equity markets for different EM countries.
9 Most recently in 1998 and 2009.10 Source: Empirical Research Partners. Data as of January 2016.
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WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER
Display 1: EM relative GDP growth vs. EM relative equity performance
2002 2014-2
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EM GDP minus DM GDP (%) (LHS)MSCI EM Equity Index vs. MSCI World Index (RHS)
Source: Factset. Data as of December 2015.
The Past, Present, and Potential Future of the EM-DM Growth DifferentialAs a result of tough reforms in the late 1990s and its 2001 entry into World Trade Organization, China’s GDP growth accelerated to an average rate of 10.8% from 2003 till 2011.11 China became the key driver for emerging market and indeed global exports and GDP growth, importing massive amounts of commodities from other EM countries, and equipment mostly from the developed countries. Growth in other EM countries rose as well, owing in part to China’s rise but also to reforms following the Asian and Russian financial crisis of the late 1990s. Increased capital flows also helped to fuel EM growth higher as it peaked at 7% of GDP in 2011 from an average of 4% average between 1980 to 2002.12
Consequently, EM equities (MSCI EM Index) experienced strong relative outperformance versus DM (MSCI World Index). From January 2001 to end 2009, EM equities gained
nearly +200% while DM returned only +4%. However, in 2010, the growth differential with DM started to decline, and market performance followed. Since then the performance relationship has reversed, with EM equities stocks down -28% while DM equities were up +30%.13
In the years following the 2008 financial crisis, we find ourselves in a low-growth world, driven by forces of debt, de-population and de-globalization which are having an outsized impact on EMs. Many emerging markets have undergone a massive credit boom over the past five plus years, and they now face the payback of their historically high borrowing in the form of lower future growth.14 Additionally, global population growth is declining, shrinking the workforce growth rates to historically low levels in many countries, and 75 percent of the decline in global working age population growth has been driven by emerging economies.15 Tellingly, 2015 marked the first year in modern history that China’s working age population actually shrank.16
Another headwind for growth is increasing evidence of “de-globalization” as global trade has grown much more slowly relative to global GDP than in the past due to a mix of cyclical and secular forces, including the slowdown in China and a rise in protectionism across the globe.17 China’s slowdown is hurting EM more than DM since many EMs came to rely on China as an export market for their goods during the last decade. For example, China is now the top export market for 44 countries, more than any other county in the world including the U.S.18 This is a fourfold increase from 2004, when China was the top export market for only 10 countries.19 China’s import content of exports is now declining and the country is no longer expanding as “the assembly plant of the world,” so other emerging economies can no longer grow by supplying equipment and raw materials to China.20 The growth slowdown in China has diminished demand for commodity imports and lowered commodity prices globally. This has disproportionately impacted EM economies and equity markets, which have a higher representation of commodities than developed markets.
11 Source: Haver Analytics. Data as of December, 2015. This is not to say China was the only country reforming. There were a number of other EMs which undertook positive reforms in the late 1990s and early 2000s but this is beyond the scope of this paper.12 Source: McKinsey Global Institute. Data as of December 2015.
13 Source: Factset. Data as of December 2015.14 “The Overlooked Risk of Credit Booms,” MSIM Journal, Volume 4 Is-sue 1 (2014)15 Haver Analytics, United Nations. Data as of Q3-201516 United Nations. Data as of Q3-201517 In 2015, a total of 539 discriminatory trade measures were reported to the GTA according to the Centre for Economic Policy Research. They noted: “In no previous year have we found so many trade distortions so quickly.” “The Tide Turns? Trade, Protectionism, and Slowing Global Growth.” CEPR, 2015.18 Source: IMF, DOT, UBS Estimates. Data as of June 2015.19 In 2000, EM exports to other EMs accounted for just 7% of GDP, while the US and Europe accounted for 13%. Now, EM exports to other EMs equates to 16% of GDP, while their exports to the US and Europe has fallen to 8%. 20 World Bank – Global Economic Prospects, “What Lies behind the Global Trade Slowdown?” – January, 2015
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For these reasons, GDP growth in the emerging markets has actually been slowing more than growth in the developed economies. The GDP growth differential between EM and DM peaked in 2007 at 6.1% but has since fallen to about 2%, as Display 2 illustrates. For reasons we discuss below, we believe that the majority of the narrowing in the EM-DM growth dif-ferential is behind us, and it should stabilize in the near future.
One key reason is that, barring a disruptive financial crisis, China’s growth is gradually slowing to a pace which we think is more consistent with its income level. Our team has maintained a very cautious stance on China and economies exposed to the country due to the numerous overhangs in the Chinese economy such as overinvestment, an unprecedented credit boom, and a shrinking working age population. While there is still a widespread belief by many that Chinese authorities can order the economy to grow at whatever rate they wish, even this faith has taken a severe hit of late. Once China’s growth adjusts lower and there is some resolution to the debt overhang, the EM-DM growth differential should stabilize.
Outside of China, there have been a number of fundamental adjustments in the EM equity asset class and EM economies over the past few years. On a number of key metrics, we are starting to see some similarities with the early 2000’s when EMs were adjusting following a serial crisis phase. The relative performance of the MSCI EM Equity index to the MSCI World Index is back to mid-2000s levels.21 Additionally, the price-to-book ratio of EM in aggregate is now trading at nearly a 40% discount to MSCI World, as it was in the early 2000s.22 On the economic front, the EM current account, even excluding China is now in surplus. EM currencies outside of China have adjusted significantly and our measure of EM real effective exchange rates ex-China is at the lows last seen in the early 2000s, in part driven by the fall in commodity prices and the hit to commodity currencies in EM.
Given these adjustments, we revisited our forecasts for growth in EM. It now appears to us that the majority of the EM growth differential narrowing is behind us. Even if we assume growth of 5% for China, this surprisingly does not lower the EM-DM growth differential very much. Part of this reflects the significant decline in the differential already experienced, over 4%. Yet, this is also because we also forecast a recovery in growth to very low rates for a few key EMs currently experiencing recessions. For example, we forecast 0% for Brazil in the coming few years, a recovery from the recent -4.5% rate, and a conservative -2% for Russia which would be a slight improvement from the nearly 4% decline in growth in 2015. In other words, realistic assumptions for growth in EM suggests the differential could stabilize from here at about 1.5% as Display 2 shows.
The risk to this view is that the leverage cycle in EM is very extended, something we have written about extensively.23 Should a number of EMs face a painful disruptive cycle characterized by a negative feedback loop between the financial sector and the real economy, we would expect a greater narrowing in the differential.
Display 2: Majority of narrowing in EM-DM GDP growth may be behind us
’15’060.0%
1.0%
2.0%
3.0%
4.0%
5.0%
6.0%
7.0%
EM GDP growth minus DM GDP growth)
Start(’01)
6.1%
2.0%1.5%
’02 ’03 ’04 ’05 ’07 ’09 ’11 ’13 ’14’10’08 ’12 Est.’16-’18
End
■ Increases in differential ■ Decreases in differential
Source: MSIM EME Team calculations, Haver Analytics, IMF. Data as of January 2016.
Ideally investors would time their investments in the EM equity asset class to the exact moment growth differentials stopped declining. Yet such exact timing can prove difficult in practice. We would simply point out that the headwinds facing EM are playing out now, and we think we are nearing the final innings. We believe that once growth differentials stabilize, so too will the relative underperformance of EM, and attempting to time one’s entry into EM equities could prove to be a costly exercise for investors.
For example, a $10,000 investment into MSCI EMs at inception in 1988 would have grown to over $72,000 by end-2015, yielding an annualized rate of return of 7.4%. Yet if an investor missed only the 10 best months over the past 27 years, the amount falls to roughly $18,000 (a 2.2% annualized return). If an investor missed only the twenty best months, they would have lost money. The initial $10,000 in 1988 would have fallen to about $6,000 for an annualized return of -1.8%.24 While we would not entirely dismiss broad market timing, the message to us is clear: when things begin to look relatively more attractive, missing out on the exact timing of a market bottom can prove costly.
23 “The Overlooked Risk of Credit Booms,” MSIM Journal, Volume 4 Issue 1 (2014) 24 Morgan Stanley Emerging Market Equities calculations, Factset. Data as of December 31, 2015. For illustrative purposes only. It is not possible to invest in an index.
21 Source: Factset. Data as of January 2016.22 Source: Factset. Data as of January 2016.
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WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER
Does growth matter in EM?Though the EM equity asset class is starting to look relatively more attractive, we believe that a passive investment in the asset class could lead to diminished returns in EM. In contrast to the developed equity markets, the “country factor” dominates returns in emerging markets. In fact, the country risk factor contribution to total returns in MSCI EM has averaged 67%, nearly double the amount for the MSCI World Index as Display 3 illustrates. Moreover, periods marked by a narrowing growth differential between EM and DM correspond to an increased contribution from the country risk factor, as Display 4 indicates.25 We are now in a low growth world and the GDP growth differential between EM and DM has narrowed substantially this decade, as compared to the past decade. As a result, we believe that now, even more than before, GDP growth will matter for EM equity investors.
Display 4: EM country contribution rose during periods of low EM-DM growth differentialEM vs. DM Growth Differentials and EM Country Contribution to Risk
12/0340%
45%
55%
65%
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Country risk factor contribution (LHS)
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Real GDP %: EM minus DM (inverted) (RHS)
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80%
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-2%
4%
6%
0%
-1%
Source: MSCI, Haver, IMF. Data as of June 2015.
Since the country effect dominates in emerging markets, several questions arise: Which factors matter for relative country performance? Should investors focus on economic growth? Do valuations matter for relative country performance? In short, we find that investing in countries with higher future economic growth has the potential to yield strong returns in excess of the MSCI EM benchmark index. Investors who have a robust framework for forecasting future economic growth prospects may be able to generate significant alpha (above benchmark returns) in the asset class.
25 There are a number of potential explanations for this, however we would surmise that in times of lower growth in EM, investors begin to distinguish more between those countries with stronger underlying economies versus those which may suffer more as EM growth slows.
Display 3: Country Factor Matters Much More in EM than DMMSCI World Index MSCI EM Index Percentage Contribution of Style, Industry and Country Percentage Contribution of Style, Industry and Country
12/030%
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12/0112/97 12/1312/05 12/1112/09
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Source: MSCI. Data as of September 2015.
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The claim that economic growth matters for relative country stock market returns is often met with skepticism in the investment community. In fact, our clients and colleagues frequently question the association between GDP growth and equity returns.
A series of papers by Jay R. Ritter26 (2005, 2012) provides the most well-known refutation of any relationship between GDP growth and equity returns. Ritter studies GDP growth and equity returns over the very long term and concludes: “the cross-country correlation of real stock returns and real per capita GDP growth over 1900-2002 is negative.”27 In other words, “investors in 1900 would actually have been better off investing…in countries with slower per capita growth.” While such long-term historical analysis is laudable—we utilize similar data ourselves when applicable—we would argue that the long-term nature of Ritter’s analysis actually underestimates the usefulness of economic growth and equity returns for a typical long-only investor in equities. Investors do not set out to predict annualized economic growth in a given country over the next 100 years, and then invest their money accordingly for the next century. Instead, their time horizon is much shorter—around three to five years—and as a result, such investors might draw very different conclusions about the relationship between growth and equity markets than that offered in Ritter’s re-search.28 In fact, Ritter himself concedes that over shorter time horizons, “There is ample evidence that unexpected changes in economic growth affect stock prices.”29
For these reasons, we decided to empirically test the relationship between economic growth and relative equity returns in a study of our own.
26 Jay R. Ritter is the Joseph B. Cordell Eminent Scholar in the Department of Finance at the University of Florida and a frequent publisher on economic topics.27 “Economic Growth and Equity Returns” Jay R. Ritter, University of Florida, Department of Finance, Insurance and Real Estate; November 1, 2004. EFA 2005 Moscow Meetings Paper.28 We should note that we find merit in many other facets of his papers. For instance we have always discounted equity returns in countries such as China where we believe their GDP growth is fuelled by questionable investment and associated with dilution of existing equity shareholders. Similarly, we have found that some countries such as Mexico whereby, despite low GDP growth, equity returns have tended to be high due to the oligopolistic nature of the economy. Despite these observations, we view these as the exceptions, not the rule. 29 “Economic Growth and Equity Returns” Jay R. Ritter, University of Florida, Department of Finance, Insurance and Real Estate; November 1, 2004. EFA 2005 Moscow Meetings Paper.
Detailed MethodologyFor our sample, we included all countries which were in the MSCI Emerging Market index in any given year, including those which are no longer members of the index in order to prevent survivorship bias. While previous studies have focused solely on developed markets, or a mixture of developed and emerging markets, we chose to isolate emerging markets simply because this is the asset class we are most interested in as EM equity investors, but also because combining EM and DM indices could potentially skew the results for a number of reasons.30
While other studies on growth and emerging market equity returns use a longer time horizon, stretching back to the 1970s or earlier, we began our study at the inception of the MSCI Emerging Market index in 1988. We chose this starting point since the emerging market equity asset class was much less accessible to international investors prior to this period. Therefore it is possible that high returns prior to 1988 could skew the results.
In order to evaluate different factors (listed below) we used a quintile approach as is common in the literature. We report the returns of the top quintile (80th percentile) versus the bottom quintile (20th percentile). For example, using the real GDP growth factor for illustrative purposes, we report the returns from investing in the countries which will grow faster than 80% of all countries and compare it to the returns of the countries which will grow slower than 80% of all countries. Since our sample covers twenty two countries on average in any given year, this means that we compared the four fastest growing countries to the four slowest growing countries. Note that our findings are robust to other measures of “high” and “low” beyond the quintile approach.
To measure performance, we used the total return indices of MSCI EM countries at the annual frequency and calculate the three-year compound annual growth return relative to the MSCI EM benchmark index. We perform this exercise each year. We then average the three year compound annual returns for countries in the top quintile of a given factor and compare it to the average of returns for countries in the bottom quintile.
For example, using the average GDP growth factor for illustrative purposes, in December of 1990, we calculated the top quintile and bottom quintile of average GDP growth rates for all EM countries through the years 1991-1993. We then calculate the three year compound annualized equity returns relative to the EM index over the period 1991-1993 for both the high and low growth countries (top and bottom quintile). This is repeated each year over our period of study (1988-2014). We then average the returns of the high and low growth countries for all years.
The factors studied included average coincident real GDP growth, the change in the average coincident GDP growth, a measure of equity valuations and a measure of currency valuation. A full description of each variable is available upon request.
30 For instance, perhaps the economic growth models of EMs are such that the relationship between growth and equity returns is different from that of DMs. An example would be the rapid industrialization growth model of China and other EMs historically which leads to high GDP growth, but low equity returns for shareholders. Similarly, it is also possible that the observed weaker corporate governance in emerging markets relative to DMs leads to lower returns as company managers may expropriate profits. Combining both EMs and DMs in the sample may distort the link between GDP growth and equities for someone interested only in the EM equity asset class. Finally, as shown above, country effect appears to matter more in EMs than in DMs. Therefore, including DMs with EMs may understate the link between GDP growth and equity returns.
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WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER
MethodologyFor our sample, we included all countries which were in the MSCI Emerging Market index in any given year.31 We began our study at the inception of the MSCI Emerging Market index in 1988. In order to evaluate different factors (listed below) we used a quintile approach as is common in investment research literature. We report the returns of the top quintile (80th percentile) versus the bottom quintile (20th percentile).32
To measure performance, we used the total return indices of MSCI EM countries at the annual frequency. We chose a three-year period for our time horizon since we think it more closely corresponds to the holding period for most long-only investors in contrast to long periods, which can distort the link between GDP growth and equity returns.33 We then calculated the three-year compound annual growth return relative to the MSCI EM benchmark index. Our reported returns throughout this paper can then be interpreted as outperforming the EM index (if positive) and underperforming the index (if negative). The factors studied included average real GDP growth, the change in the average GDP growth, a measure of equity valuations, and a measure of currency valuation.
Results*
High Absolute Growth MattersFirst, we tested for the impact of high and low GDP growth by following the top and bottom quintile approach described above. Note for GDP growth we are assuming accurate foresight into future GDP growth.34 In other words, in December of 1990, we assume one knows which countries will grow the fastest over the next three years (1991 to 1993) and which countries will grow the slowest and then invest accordingly such that we report the returns from 1991 to 1993.
We found that high growth EMs have outperformed the MSCI EM index by an average of 4.1% a year, while low growth EMs underperform the MSCI EM index by 0.7% a year as Display 5 illustrates.35
34 Note that one needn’t be able to accurately forecast the exact GDP growth rates to the second decimal for every country. Rather one simply needs to forecast the relative order of EM country growth rates. Specifically, one would need to forecast only the four fastest growing countries over the next three years and the four slowest growing countries over the coming three years.35 Note that these findings span the period from 1992 to 2014. We chose 1992 as a starting point because it marked the year many large countries entered the index such as China, India, South Africa, Poland, Colombia and Peru, creating a larger and more robust sample size. That said the findings hold if we change the starting point to the MSCI inception in 1988 as high growth countries outperform low growth countries by a spread of 3.7% a year on average. 29 Note that these findings span the period from 1992 to 2014. We chose 1992 as a starting point because it marked the year many large countries entered the index such as China, India, South Africa, Poland, Colombia and Peru, creating a larger and more robust sample size. That said the findings hold if we change the starting point to the MSCI inception in 1988 as high growth countries outperform low growth countries by a spread of 3.7% a year on average.
*For illustrative purposes only. Results are hypothetical in nature, based on the Emerging Markets Equity (EME) team’s analysis and calculations as described. Results are not indicative of the historical or future performance of any specific investment. Hypothetical results, which are created with the benefit of hindsight, have inherent limitations. They were not produced under actual market conditions and cannot completely account for the impact of financial risk of actual investing. Furthermore, indexes used are unmanaged, are listed in U.S. dollars, assume the reinvestment of dividends and do not include fees or expenses. It is not possible to invest directly in an index.31 We included countries which are no longer members in the MSCI EM index so as not to subject our results to survivor bias, including Argentina, Israel, Jordan, Morocco, Pakistan, Portugal, Sri Lanka, and Venezuela during the years in which they were members of the MSCI EM Equity index.32 In addition to testing the top and bottom quintiles (80th/20th percentiles) which we report in the paper, we also tested the top and bottom quartiles (75th/25th percentiles), the top and bottom deciles (90th/10th percentiles), and above or below the median (above 50th percentile vs. below 50th percentile). In all cases, investing in high growth led to higher returns, although the magnitude of the returns vary slightly depending on which measure one uses.33 We report the three-year holding period returns in the paper, but our findings are robust to horizons of two years and five years as well. In other words, using a two or five year periods does not significantly alter our findings in any way.
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Display 5: High Growth Countries Outperformed, Low Growth Countries Underperformed
Low GrowthHigh Growth-2.0%
0.0%
2.0%
3.0%
4.0%
5.0%
1.0%
4.1%
-0.7%-1.0%
Source: MSIM EME Team Calculations, Factset. Average three-year annualized return relative to MSCI EM Index. Data as of December 2015.
High change in growth mattersNext we examined the impact of the change in GDP growth on relative returns. Here we are interested in the change in the average growth rate. For example, in December 1990, we are taking the difference in average GDP growth from the three years prior (1988 to 1990) and the three years in the future (1991 to 1993) and then calculating the returns from 1991 to 1993. As such, this factor will capture which countries saw the largest acceleration (or smallest deceleration) in growth and which had the largest deceleration (or smallest acceleration) in growth. Interestingly, the return dispersion between high changes in GDP growth and low changes in GDP growth is even higher than the rate of GDP growth we discussed prior. In other words, if it can be achieved, accurate foresight about which countries will witness the highest change in their growth rate over the coming three years as compared to the prior three years is very valuable.36
We found that the top quintile of the change in GDP growth outperformed by 9.6% a year, while the bottom quintile underperformed by 4.4%.
Display 6: GDP Accelerations Substantially Outperformed, GDP Decelerations Underperformed
Large Growth DecelerationLarge Growth Acceleration-6.0%
0.0%
4.0%
6.0%
8.0%
12.0%
2.0%
9.6%
-4.4%-4.0%
-2.0%
10.0%
Source: MSIM EME Team calculations, Factset. Average three-year annualized return relative to MSCI EM Index. Data as of December 2015.
One reason why the change in growth delivers a wider return dispersion is likely due to its impact on profit margins and earnings for various firms. Changes in GDP growth correlate well with earnings growth due to “operating leverage” in EM. In other words, as headline growth slows to take one example, profits take a double hit: first because of the slowdown in rev-enue and second because of the high fixed operating and capital costs in EM. The opposite happens in periods of acceleration in growth: profits rise due to higher revenue growth, yet fixed costs do not increase at the same rate giving a double boost to profits.
In short, a high absolute growth rate along with a high change in growth rate may be the best combination for relative outperfor-mance of a country.
Academic literature on growth and stock market returnsOur findings are similar to a study by Elroy Dimson, Paul Marsh and Mike Staunton.37 Using data on 85 EM and DM countries going back to 1972, they found that a clairvoyant GDP forecaster would be able to generate “far higher annualized returns” by investing in the “equities of economies that are going to have high growth over the years ahead” as opposed to “buying into economies that are going to suffer poor growth,” over one, three, and five year holding periods. They also found that the higher the future GDP growth, the higher the future returns. Dimson et al found no evidence of small or large country premium, so the overriding influence of expected GDP growth is not altered by country size, whether in EM, DM or frontier markets.
37 Source: Returns from 1972 – 2013. Credit Suisse Global Investment Returns yearbook 2014, Elroy Dimson, Paul Marsh, Mike Staunton using data from Barro and Maddison.
36 Past performance is no guarantee of future results.
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WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER
To evaluate portfolio performance, they looked at total returns drawn from lowest growth, middling growth and highest growth countries. The display below shows five-year annualized returns from selecting markets that are destined to experience high and low growth in GDP after the portfolio undergoes investment. The lowest growth countries yielded only 4% annualized returns over five years and the highest growth countries yielded 29%.
Display 7: Five-year Annualized return on markets sorted by real per capita GDP growth in the future, 1972-2013
Middling growthin the future
Lowest growthin the future
0.0%
15.0%
25.0%
30.0%
35.0%
20.0%
4%
29%
5.0%
10.0%
Highest growthin the future
17%
Returns from 1972 to 2013. Credit Suisse Global Investment Returns yearbook 2014, Elroy Dimson, Paul Marsh, Mike Staunton using data from Barro and Maddison. Data as of December 2013.
In addition, Dimson, Marsh and Staunton found that portfolios based on high GDP growth over the past do not perform well. Pure extrapolations from the past do not lead to outperformance historically. Lowest growth in the past and highest expectations of future growth yielded the best hypothetical investment results.
Display 8: Annualized returns of portfolios sorted by real per capita GDP growth in the past and future, 1972-2013
Highest growthin the past
Lowest growthin the past
0.0%
15.0%
25.0%
30.0%
35.0%
20.0%
24%
29%
5.0%
10.0%
Highest growthin the future
15%
Returns from 1972 to 2013. Credit Suisse Global Investment Returns yearbook 2014, Elroy Dimson, Paul Marsh, Mike Staunton using data from Barro and Maddison. Data as of December 2013.
Do valuations really matter in EM country allocation?We found that on average, there is little evidence that cheap valuations are a compelling reason to buy stocks.38 We discovered that both very cheap (bottom quintile) and very expensive (top quintile) EM country indices tended to outperform the index by a similar magnitude. In other words, there is no dispersion among returns based on cheap versus expensive, calling into question its usefulness. Specifically, the average outperformance of cheap countries was 2.4% a year, while the average outperformance of expensive countries was 2.5% a year. Interestingly, unlike with other factors we tested, we found a lot of variation in the average returns of cheap countries, suggesting the median is a more appropriate measure. If we compare the median returns of cheap vs. expensive countries, we found that the median cheap country underperformed by 0.5% a year, while the median expensive country outperformed the index by 1.3% a year. Surprisingly, this suggests that expensive markets tend to outperform cheap markets.
Display 9: No Evidence that Cheap Countries Outperform Expensive Countries
CheapExpensive-1.0%
1.0%
2.0%
2.5%
3.0%
1.5%
2.5%
-0.5%-0.5%
0.0%
2.4%
1.3%
0.5%
■ Average ■ Median
MSIM Calculations, Factset. Average three-year annualized return relative to MSCI EM Index. Data as of December 2015.
Valuation spreadsValue may work as a strategy for country allocation when valuation spreads (differences in valuation between cheapest and most expensive quintile of markets) are well above average, or one standard deviation. This typically happened during crises episodes such as 1997.39 Relative returns of value in such cases were better for about two years after the episodes. We believe that valuation opportunities can occur in EM, but they are
38 Defined as bottom quintile of the price-to-book value z-score (5-year). We tested other valuation metrics, such as dividend yield which is favored by many such as Ritter, but found similarly that expensive outperformed cheap.39 Empirical Research Partners. Data as of December, 2015.
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very rare and happen only during crises. As an EM investor, we consider betting on value when we believe the odds are stacked in our favor. When valuation spreads are above average, we start paying close attention to value but only when they get to one standard deviation (SD) above average do we reasonably believe that there may be a value opportunity emerging. At the moment, they are rising and stand at 0.65 SD above average.40
While cheap valuations tend not to work for equity market country allocations, we found that currency valuations do offer some valuable information. A number of studies have suggested that an overvalued currency is often a sign of future real economy troubles.41 As such, currencies play a vital role in any EM country allocation analysis. We have found that since inception in 1988, EM currencies have accounted for one-third of the annual total returns of the MSCI EM index (denominated in USD) as Display 11 illustrates. While there are many different ways to account for currency valuation in the literature, we chose one of the simpler metrics for illustrative purposes: the real effective exchange rate deviation from its 5-year average. We then calculated the top and bottom quintiles of this variable. We found that investing in countries with the “cheapest” (or bottom quintile) real effective exchange rate led to an average annualized return of 4.5% above the EM index. Investing in “expensive” currencies underperformed the EM index by about 1% a year on average.
Display 11: Countries with Cheap Currencies Outperformed, Expensive Currencies Underperformed
Expensive REERCheap REER-2.0%
0.0%
2.0%
3.0%
4.0%
5.0%
1.0%
4.5%
-0.9%-1.0%
Source: MSIM EME Team calculations, Bruegel, Haver, Factset. Data as of December 2015.
We have shown how real GDP growth and currency matters for EM investing, and that valuations may have less predictive power than widely believed. It’s also worth pointing out how nominal GDP—GDP growth including the boost from infla-tion and the exchange rate—coincides with nominal country returns. Over the medium- to long run, dollar GDP growth appears to drive market earnings.
Display 13 shows stock market returns led forward 6 months and CAGR of nominal GDP for each country since they were introduced in the MSCI EM (ex-China) Index. Plotting the average of all the annual returns and the average of all the GDP growth for each country you see that relative stock market returns are associated with relative nominal GDP growth. Reasonable predictions of real growth and assessments of currency valuation are integral to our top-down process.
Display 10: Currencies Contributed One-Third of MSCI EM Total Returns on Average
20150%
20%
30%
40%
50%
60%
70%
80%
90%
10%
1988 1989 2003200220012000 20141999 20131998 20121997 20111996 20101995 20091994 20081993 20071992 20061991 20051990 2004
46%43% 42%
17%
9%
57%
16%
57%
12%
62%
19%
7%
77%
25%
36%
25%
67%
21%
56%
13%
37%
16%
45%
11%
33%
3%
56%
37%
Source: MSIM Calculations, Factset. Data as of December 2015.
40 Source: Empirical Research Partners. As of January 22, 2016. 41 Dornbusch, Godfajn and Valdes (1995), Kaminsky, Lizondo and Reinhart (1998) and Gourinchas and Obstfeld (2012) are a few such papers.
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WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER
Display 12: Nominal GDP growth (x axis) and nominal stock market returns (y axis)
15%5%0%
10%
20%
25%
30%
Equi
ty %
Cha
nge
14%
EgyptColombia
ChileBrazilCzech Republic
Korea
Mexico
Malaysia
Indonesia
Hungary
GDP % Change
5%
15%
6% 7% 8% 9% 10% 11% 12% 13%
India
Taiwan
South Africa
Russia
Poland
Philippines
Peru
Morocco
Turkey
Thailand
Source: Haver Analytics, Factset. Data as of December 2014.
Performance Post Global Financial CrisisOur study covers the EM equity class since the inception of the MSCI EM index in 1988. However, the curious reader will surely wonder whether our findings track for the more recent post-crisis period. Display 14 illustrates how applying our find-ings from 2009 to 2015 would have performed and reiterates our key findings from above. Have the highest growth countries on average outperformed the MSCI EM Index? Accurate forecasts for the highest and lowest growing countries from 2009-2015 would have been very valuable. The return spread between the highest and lowest growing countries was 9.3% per year on average as the highest growers outperformed the MSCI EM index by 2.6% a year, while the lowest growth EMs underperformed the index by 6.7% a year on average. Countries which had the largest change in GDP growth outperformed by 2.3% a year on average over the 2009-2015 period, while those with the lowest change in growth underperformed by 5.3% a year, for a spread of 7.6% a year. Countries with “cheap” equity markets have underperformed the index by 2.0% a year on average in the post-crisis period, while the “expensive” equity markets have outperformed by 2.6% a year. Finally, “cheap” currencies slightly outperformed by 0.40% a year on average, while “expensive” currencies underperformed by 2.2% a year, for a spread of 2.60%.
Display 13: Average Annualized Returns Relative to EM Index (2009 to 2015)
-8%
Expensive Currency
Cheap Equity Market
Low Change in Growth
Low Growth
Cheap Currency
Expensive Equity Market
High Change in Growth
High Growth
-2% 0% 2%-6% 4%-4%
2.6%
2.3%
2.0%
0.4%
-6.7%
-5.3%
-2.6%
-2.2%
Source: MSIM EME Team calculations, Factset. Data as of December 2015.
SummaryWelcome to the low growth world, characterized by debt, de-population, and de-globalization. The bar for economic success likely needs to be lowered for countries across all income categories. In an environment marked by lower growth, the ability to spot countries which are likely to grow the fastest becomes all the more important and during periods in which the EM-DM growth differential is low, the variation in returns between different EM countries rises.
If history is any guide, our analysis indicates that EM investors with a robust framework for distinguishing between the fastest and slowest growing countries, in addition to spotting growth accelerations, may be able to outperform by a substantial degree.42 Furthermore, as we have discussed, currency valuation is a vital component of the country allocation process in EM, while equity valuation only seems to matter at extremes.
The year 2016 is likely to be a crucial one for EM as the economic and financial adjustment for many countries appears to be enter-ing the final stages. In this respect, China, of course, outweighs all other countries in EM and we need to gain greater clarity on their currency and growth policy, in addition to how they intend to handle the debt overhang before we turn very positive.
That said, the EM-DM GDP growth differential, which tends to correlate well to EM-DM relative equity performance, has already narrowed significantly. Correspondingly EM has underperformed DM equities for the past six years or so. Going forward, any incremental narrowing will pale in comparison to the decline we have already witnessed. The case for increasing allocations to EM relative to DM is more compelling today than at any point since the global financial crisis.
42 Past performance is no guarantee of future results.
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About the AuthorsJITANIA KANDHARIExecutive DirectorJitania is head of macroeconomic research on the Global Emerging Markets Equity team focusing on global analytics, country and thematic research. She joined Morgan Stanley in 2006 and has 17 years of investment experience. Prior to joining the firm, Jitania was an emerging markets consultant at GMO. Previously, she was an associate vice president in private banking at ABN Amro, an associate vice president in securities brokering and investment banking at Kotak Securities, and a manager at First Global Securities. Jitania received a B.Com. in advanced financial and management accounting and an M.M.S. in finance, both from the University of Bombay.
STEVEN QUATTRYVice PresidentSteven is an analyst on the Global Emerging Markets Equity team, focusing on global macro-economic and thematic research. He joined Morgan Stanley in 2011 and has eight years of investment experience. Prior to joining the firm, Steven was an analyst at Panda Global Advisors, concentrating on economic and investment research. Previously, he was in the financial management program at GE Capital. Steven received a B.A. in finance from the University of Florida and an M.A. in international affairs, with a focus on international economic policy, from Columbia University.
About Morgan Stanley Investment Management43 Morgan Stanley Investment Management, together with its investment advisory affiliates, has 596 investment professionals around the world and approximately $404 billion in assets under management or supervision as of September 30, 2015. Morgan Stanley Investment Management strives to provide outstanding long-term investment performance, service and a comprehensive suite of investment management solutions to a diverse client base, which includes governments, institutions, corporations and individuals worldwide. For more information, please visit our website at www.morganstanley.com/im. This material is current as of the date specified, is for educational purposes only and does not contend to address the financial objectives, situation or specific needs of any individual investor.
43 Source: Assets under management as of September 30, 2015. Morgan Stanley Investment Management (“MSIM”) is the asset management business of Morgan Stanley. Assets are managed by teams representing different MSIM legal entities; portfolio management teams are primarily located in New York, Philadelphia, London, Amsterdam, Hong Kong, Singapore, Tokyo and Mumbai offices. Figure represents Morgan Stanley Investment Management’s total assets under management/supervision.
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WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER
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DEFINITIONSCompound Annual Growth Rate (CAGR) is the year-over-year growth rate of an investment over a specified period.
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