Emerging and frontier markets encompass some of the fastest-growing globally. We believe that the sustained expansion of these Markets offers compelling opportunities across various industries. Our index-agnostic, opportunistic approach enables us to identify and capitalize on promising growth prospects that many investors may overlook.
While organizations such as the World Bank, the International Monetary Fund (IMF), and the United Nations may use slightly different criteria to assess a country’s stage of economic development, MSCI’s definitions are the standard starting point for investors. Generally, countries are classified as developed, emerging, or frontier, with some, like Argentina, holding standalone status.
Countries can transition between these categories, receiving upgrades or downgrades based on several factors beyond GDP, according to a predetermined schedule. MSCI not only evaluates economic data but also considers market size and liquidity. The underlying assumption is that liquidity, like risk, operates along a spectrum that ranges from developed Markets to emerging Markets, and then to frontier Markets. Typically, the more developed a country is, the more liquid its market, and vice versa.
10 reasons to allocate to emerging Markets
The primary reasons for investing in emerging market equities have traditionally included higher growth rates and lower valuations compared to developed Markets, along with the advantage of diversification. These factors remain compelling, as attractive valuations and low correlations continue to draw interest. Growth prospects are expected to improve as monetary policy loosens, with GDP growth in emerging Markets projected at 4.3% in 2024, significantly higher than the 1.7% forecast for developed, as illustrated in the first chart below.
Beyond strong growth potential and appealing valuations, several additional factors reinforce the argument for increasing exposure to emerging Markets. Firstly, emerging market currencies are currently undervalued relative to the US dollar compared to previous market cycles. Secondly, emerging Markets have historically delivered superior performance over multi-year cycles. We anticipate that several potential catalysts—such as rising commodity prices, the end of deflation, and economic reforms—could drive a future period of outperformance. Thirdly, many emerging are implementing pro-growth policies, and their debt levels are generally less burdensome than those of developed nations, providing further momentum.
From a portfolio construction perspective, allocating to emerging Markets offers valuable diversification benefits, as this asset class demonstrates low correlations with other regional equity indices. We believe this can contribute to additional alpha in a global equity portfolio. Positioning data provided below indicate that most global investors are currently underweight in this asset class. However, we believe that the combination of these factors could trigger a shift toward greater investment in emerging Markets.
Emerging market performance comes in cycles
It’s not only emerging market equities that are undervalued; emerging market currencies are also significantly cheap. The Bloomberg Emerging Market Currency Index has declined to its lowest level since its inception. As depicted in the chart below, this index strengthened against the US dollar both during the super-cycle of the 2000s and in the recovery period following the Global Financial Crisis (GFC).Although the MSCI Emerging Market Equity Index has underperformed the MSCI ACWI Equity Index in recent years, it has delivered superior long-term performance, driven by periods of significant gains that have occurred in waves.
Source: Bloomberg
Since its inception on December 31, 1987, the MSCI Emerging Markets Index has outperformed the MSCI ACWI, delivering an average annual total return of 8.8% compared to 7.8% for the MSCI ACWI—a difference of 1% per annum. We have segmented the relative performance of these two indices into four distinct periods, as indicated by the arrows on the chart above.
12/31/87 – 12/31/97: EM +19.7% p.a, ACWI +9.2% p.a.
The first wave spanned from the launch of the emerging market asset class on December 31, 1987, until the onset of the Asian Financial Crisis in the latter half of 1997. During this period of optimism surrounding the new asset class, emerging Markets achieved an annual return of 19.7%, surpassing the MSCI ACWI’s annual return of 9.2% by over 10%.
12/31/97 – 12/31/02: EM -4.8% p.a., ACWI -1.8% p.a.
The emerging Markets crises of the late 1990s coincided with the US technology boom, which ultimately led to the global bear market known as the ‘tech wreck’ in the early 2000s. From December 31, 1997, to December 31, 2002, emerging Markets underperformed, with an average annual loss of 4.8%, compared to the MSCI ACWI’s more modest annual loss of 1.8% during the same period.
12/31/02 – 12/31/07: EM +37.3% p.a., ACWI +18.9% p.a.
The conclusion of the bear market marked the beginning of the ‘super cycle,’ a phase of robust global growth driven by Chinese urbanization and industrialization, which persisted until the Global Financial Crisis (GFC) in 2008. This ‘super cycle’ was characterized by the strongest absolute and relative performance for emerging Markets. From December 31, 2002, to December 31, 2007, the MSCI Emerging Markets Index recorded an annual gain of 37.3%, significantly outpacing the MSCI ACWI Index, which achieved an annual gain of 18.9%.
12/31/08 – 06/30/24: EM +7.2% p.a., ACWI +11.2% p.a.
The years following the Global Financial Crisis (GFC) have been particularly disappointing for emerging market investors on a relative basis. Since December 31, 2008, the MSCI Emerging Markets Index has delivered an annualized return of 7.2%, compared to the MSCI ACWI’s annual return of 11.2%, resulting in a performance gap of 4.0% per year. This prolonged period of below-average returns and the perceived absence of catalysts for emerging market outperformance have frustrated investors.
Emerging market growth is stronger
Source: Bloomberg
The key to achieving more robust growth lies in lowering inflation, which wouldenable central banks to reduce policy rates. The recent inflation has been driven by a combination of supply chain bottlenecks and pent-up consumer demand following the COVID-19 pandemic, further intensified by government spending on infrastructure and social programs.
Source: Bloomberg
Emerging Markets have cheaper valuations
Since the recovery from the Global Financial Crisis (GFC) in 2008, emerging market equities have consistently been valued more cheaply than global equities, with the valuation discount widening for more than a decade.
Source: Bloomberg
Developed Markets | Emerging Markets | Emerging Market Discount | |
|---|---|---|---|
12-month Forward P/E | 18.3x | 12.7x | -30.6% |
Average P/E | 15.2x | 12.2x | -19.7% |
Premium | 20.41% | 4.1% |
Source: Bloomberg
The price-to-earnings discount between the MSCI ACWI and MSCI Emerging Markets Indices has expanded to an above-average level of 30%, as illustrated in the chart and table above. This widening is primarily due to the premium multiple assigned to the MSCI ACWI global index, which includes the highly valued U.S. market. The valuation gap is linked to company earnings, with the chart below highlighting the divergence in corporate earnings growth between emerging and developed Markets since monetary policy tightening began in 2021. However, this gap is expected to narrow over time.
Source: Bloomberg
Emerging market currencies are cheap
It’s not only emerging market equities that are undervalued; emerging market currencies are also significantly cheap. The Bloomberg Emerging Market Currency Index has declined to its lowest level since its inception. As depicted in the chart below, this index strengthened against the US dollar both during the super-cycle of the 2000s and in the recovery period following the Global Financial Crisis (GFC).
Source: Bloomberg
A number of catalysts point to an emerging equity market recovery
Emerging market equities have historically performed well during periods when the yield curve steepens and commodity prices strengthen, as these conditions signal reflation and increased nominal GDP growth. Since 2021, rising interest rates have pushed the US 10-year Treasury bond yield to its highest level since the mid-2000s. This shift indicates the end of the disinflationary environment that persisted from 2010 to 2020, suggesting a potential recovery for the emerging market asset class.
Source: Bloomberg
Commodities have also started to recover, particularly industrial and precious metals like copper and gold. The Commodity Research Bureau (CRB) Index began to rise around the same time as the US 10-year Treasury yield; however, it remains significantly below its peak levels from the mid-2000s.
Source: Bloomberg
Our analysis of the relationship between industrial and precious metals, the US 10-year Treasury yield, and the MSCI Emerging Markets Equity Index reveals that industrial metals are a significant driver of returns. The signal for industrial metals has recently turned positive.
Source: Bloomberg
Indebtedness is generally less burdensome for emerging than advanced
A key characteristic of bear Markets and financial crises over the past 30 years—until the COVID-19 pandemic—has been the trend of declining interest rates. The expectation of persistently low rates led to complacency regarding higher levels of debt. As a result, advanced now generally face greater debt burdens compared to most emerging.
Source: Bloomberg
The fiscal expansion implemented in response to the COVID-19 pandemic has led to inflation and interest rates that are higher than any time since the mid-2000s. High levels of indebtedness and elevated interest rates generally result in slower growth, as funds are directed toward debt servicing rather than investment. Additionally, concerns about sovereign creditworthiness in developed Markets could lead to higher bond yields and reduced valuations. In contrast, most emerging Markets already experience higher bond yields and lower valuations compared to developed Markets. This more favorable debt profile could support relatively better performance for emerging Markets as the impact of deteriorating financial conditions is factored into the more expensive bond and equity valuations in advanced.
Emerging countries continue reforming
Excessive debt has precipitated several financial crises since the emergence of the asset class in the late 1980s. The Tequila Crisis of 1994–1995, along with the Asian and Russian Crises of 1997–1998, led to financial aid packages conditioned on the adoption of orthodox economic policies, which ultimately stimulated growth and enhanced emerging market returns. Currently, Egypt and Turkey are implementing new economic strategies aimed at improving public finances and attracting foreign investment. In the Middle East, Saudi Arabia’s ‘Vision 2030’ aims to create a modern and dynamic society, reduce dependence on oil, and foster a globally ambitious economy. Additionally, Korea’s ‘Value-up’ program seeks to improve shareholder returns and address the persistent valuation discount compared to other emerging Markets. These efforts are expected to positively impact emerging market equity performance.
Under-owned Markets
Despite strong fundamentals, attractive valuations, and potential catalysts for emerging equity Markets, long-term relative underperformance has led many investors to avoid this asset class.
Source: Bloomberg
Global equity investors have consistently reduced their exposure to emerging Markets, either due to underperformance or through reallocation to other asset classes. Should emerging Markets begin to outperform, it is likely that increased inflows would follow, boosting exposure to this under-owned asset class.
Emerging Markets are under-capitalized in relation to GDP
Emerging Markets are both under-owned and under-capitalized. The ‘Buffett Indicator,’ which measures the ratio of total market capitalization to GDP, suggests that a market capitalization below 100% of GDP indicates relatively attractive value.
Source: Bloomberg
Developed Markets, including the US, the UK, and Japan, are capitalized at levels exceeding 100% of GDP, suggesting relatively high valuations or a concentration of large multinational corporations headquartered and listed in these countries. In contrast, most emerging Markets, with the exception of Saudi Arabia—home to the global energy giant Aramco—are capitalized below 100% of GDP. This indicates that their valuations are relatively attractive and that the potential for equity growth is higher in emerging Markets compared to developed Markets. Additionally, under-capitalized Markets often serve as excellent diversifiers in a global portfolio.
EM is one of the best global diversifying equity allocations
Among the major regional MSCI indices, emerging Markets continue to offer diversification benefits and potential for alpha in efficient global equity portfolios due to their relatively low correlation with other regions.
MSCI USA | MSCI EAFE | MSCI EM | MSCI FRONTIER | |
|---|---|---|---|---|
MSCI USA | 1.00 | 0.76 | 0.67 | 0.56 |
MSCI EAFE | 0.76 | 1.00 | 0.71 | 0.65 |
MSCI EM | 0.67 | 0.71 | 1.00 | 0.62 |
MSCI FRONTIER | 0.56 | 0.65 | 0.62 | 1.00 |
Source: Bloomberg
The relatively low correlations and attractive valuations of emerging market equities suggest that this asset class represents an efficient allocation on a risk/return basis, as demonstrated by the efficient frontier.
Source: Bloomberg
A global equity portfolio incorporates an allocation to emerging Markets even at the minimum variance level. This exposure is included to seek higher returns and to construct the maximum return portfolio, which, in theory, could be composed entirely of emerging Markets equities.
Estimated Return % | Estimated Volatility % | Risk Adjusted Return | |
|---|---|---|---|
Minimum Variance MSCI US 43.3% MSCI EAFE 34.8% MSCI EM 21.9% | 5.8% | 9.8% | 0.59 |
Maximum Return MSCI US 0.0% MSCI EAFE 0.0% MSCI 100.0% | 7.5% | 12.7% | 0.59 |
Source: Bloomberg
In this example, allocations to emerging Markets are efficient, as increased risk corresponds to higher potential absolute and risk-adjusted returns.
Emerging Markets have cheaper valuations
Since the recovery from the Global Financial Crisis (GFC) in 2008, emerging market equities have consistently been valued more cheaply than global equities, with the valuation discount widening for more than a decade.
Developed Markets | Emerging Markets | Emerging Market Discount | |
|---|---|---|---|
12-month Forward P/E | 18.3X | 12.7X | -30.6% |
Average P/E | 15.2X | 12.2X | -19.7% |
Permium | 20.41% | 4.1% |
The price-to-earnings discount between the MSCI ACWI and MSCI Emerging Markets Indices has expanded to an above-average level of 30%, as illustrated in the chart and table above. This widening is primarily due to the premium multiple assigned to the MSCI ACWI global index, which includes the highly valued U.S. market. The valuation gap is linked to company earnings, with the chart below highlighting the divergence in corporate earnings growth between emerging and developed Markets since monetary policy tightening began in 2021. However, this gap is expected to narrow over time.
