Rising from the ashes of a vicious fourth quarter correction in 2018, US equities performed admirably in 2019 despite a backdrop of slowing growth, increasing geopolitical risks, and recession fears. Similarly, emerging market (EM) equities still managed to post double-digit returns as of November, but suffered as trade tensions flared and risk aversion drove investors away from high beta risk assets.

While emerging markets have grown steadily to overtake developed markets in their contribution to global growth, emerging market equities are still very much subject to boom-bust cycles. Capital markets in emerging economies lack the depth of their developed counterparts, which can at times leave performance at the mercy of capital flows and investor positioning. This is a double-edged sword – it can make the good times even greater and the bad times even darker. While the long-term prospects for emerging markets appear bright – driven in part by young and growing populations – market dynamics can present risks but also opportunities for EM investors in the short term. Looking forward to 2020, fundamental and technical factors are aligning in a way that suggests these dynamics could help to fuel a strong year for the space.

EM Growth Continues to Hold Up
While growth as measured by Purchasing Managers’ Index (PMI)1 data softened materially in 2019, it appears a gap has begun to widen between PMIs for developed and emerging economies. As growth momentum in developed economies has remained weak, emerging markets have fared much better, with manufacturing PMIs creeping back into expansionary territory.

Manufacturing Purchasing Managers' Index
(9/30/15 - 10/31/19)

Manufacturing Purchasing Managers' Index (9/30/15 - 10/31/19)
Source: FactSet

Looking ahead to 2020, forward indicators are pointing to a further recovery in growth for emerging countries and the broader global economy. The synchronized global growth narrative of 2017 and early 2018 has shifted to one of synchronized global easing, as central banks have become more accommodative in an attempt to counter slowing growth. Monetary policy, however, works with a lag – it can take time for interest rate cuts to stimulate growth. In addition to monetary tools, some EM countries have also turned to fiscal measures to support growth. With EM PMI data inflecting higher and global manufacturing PMI following suit, it appears that this stimulus is beginning to have its intended effect.

Manufacturing PMI vs EM Central Bank Policy
(1/30/98 - 10/31/19)

Manufacturing PMI vs EM Central Bank Policy (1/30/98 - 10/31/19)
Source: FactSet

On the corporate side, earnings expectations for 2020 also point to a potential growth advantage for EM equities relative to US and international developed equity markets. Full year 2020 earnings have crept up to over 14% for MSCI EM while S&P 500®2 and MSCI EAFE3 have seen estimates revised downward in recent months to 9.6% and 7.1%, respectively, as of November 2019. Relative earnings growth has historically been one of the key drivers of relative equity performance, and this leans heavily in favor of EM equities in 2020.

Full Year 2020 Earnings Estimates Evolution
(12/31/17 - 10/31/19)
Full Year 2020 Earnings Estimates Evolution (12/31/17 - 10/31/19)
Source: FactSet

Valuations Remain Attractive
While EM equities have the potential to deliver a significant growth premium over developed markets, valuation multiples still remain historically cheap. EM valuations are slightly rich as compared to the historical average, but they are trading at a material discount to developed equities, with MSCI EM priced at a 26% discount relative to the S&P 500® and 20% to the MSCI World. At such cheap levels and with sound fundamentals, the stage could be set for significant EM outperformance from the perspective of mean reversion.

Emerging Market Valuations
(12/31/08 - 10/31/19)
Emerging Market Valuations (12/31/08 - 10/31/19)
Source: FactSet

Supportive Technicals
With thinner liquidity relative to developed equity markets, investor flows and positioning are a key risk factor for emerging market equities. As global growth slowed and trade tensions flared in early 2019, investors soured on emerging markets and headed for the exits en masse. From February through October, EM equities experienced outflows in 32 of 36 weeks totaling over $55 billion. With investor positioning still light, emerging market equities could be primed for a move higher, fueled potentially by strong fundamentals and performance-chasing inflows as risk appetite recovers.

Emerging Market Equity
Weekly Flows (11/18/16 - 11/15/19)
Emerging Market Equity Weekly Flows (11/18/16 - 11/15/19)
Source: FactSet

Promising Conditions?
Recovering growth, solid earnings expectations, attractive valuations, and light investor positioning all paint an appealing picture for emerging markets in 2020. Fundamentals and technicals aside, however, there remains one additional factor that bodes well for emerging markets.

The glut of accommodative monetary policy has led to a sharp easing in financial conditions. Financial conditions indexes can be considered something of a catch-all for the availability and price of credit, including factors such as risk-free rates, foreign exchange rates, equity valuations, and credit spreads. Significant and synchronized central bank easing has led to a marked easing in financial conditions, helping to reduce rates and cap US dollar strength – two key factors for emerging markets that have the potential to increase investor risk appetite.

Changes in financial conditions have historically been a strong predictor of emerging market equity performance. In fact, since 2009, 76% of the performance of emerging markets equities can be explained by changes in financial conditions.4 All told, with the Fed presumably on an extended pause and global central banks still exhibiting a dovish tilt, financial conditions should remain accommodative, which could provide significant support for emerging market performance in 2020.

Emerging Market Equity Performance and Financial Conditions
(12/31/09 - 10/31/19)
Emerging Market Equity Performance and Financial Conditions (12/31/09 - 10/31/19)
Source: Bloomberg

Emerging Market Debt
Many of the same catalysts that project to benefit emerging market equities also create a favorable backdrop for emerging market debt, both in local and hard currency terms. Benign global inflation and accommodative policy from developed market central banks have created a supportive environment for EM debt. This policy easing has also created more flexibility for emerging market central banks to continue to ease to support growth. With generally sound fundamentals and growth rebounding, local and hard currency emerging market debt may offer an attractive carry to generate incremental yield in a yield-starved investment landscape.

Accounting for Risk
Every market outlook should consider risks – and EM is no different. If the growth recovery falters, emerging markets and international equities in general could suffer as they are levered to global growth. However, the downside could be limited by already cheap valuations and light investor positioning. Contagion, or the spread of economic difficulties from one country to another, is always a possibility, even for developed markets. Recently, emerging markets have remained resilient to this risk even as political turmoil and economic turbulence has risen in countries like Turkey, Argentina, and Chile.

Foreign exchange risk is always a consideration as well when investing in non-dollar assets. While the US dollar has been stubbornly strong in recent years, the increasing growth differential between EM economies and the US economy, as well as a recovery in global growth, should help to at least put a cap on the greenback and potentially weaken it relative to EM currencies. Finally, the elephant in the room, trade tensions could always flare up with little notice. What’s encouraging, however, is that markets appear to have grown increasingly resilient to trade headlines, and there is evidence that a global growth rebound is under way despite a lack of resolution on the trade front.

Investing is always a careful balance of risk and return. For emerging markets, there is evidence that the risk-reward skew could be shifting in favor of a strong 2020.
1 The Purchasing Managers' Index (PMI) is an index of the prevailing direction of economic trends in the manufacturing and service sectors. It consists of a diffusion index that summarizes whether market conditions, as viewed by purchasing managers, are expanding, staying the same, or contracting.

2 The S&P (Standard & Poor’s) 500® Index is an index of 500 stocks often used to represent the US stock market.

3 The MSCI EAFE Index is a stock market index that is designed to measure the equity market performance of developed markets outside of the US & Canada. It is maintained by MSCI Inc., a provider of investment decision support tools; the EAFE acronym stands for Europe, Australasia and Far East.

4 Based on a regression of MSCI EM monthly returns against the monthly change in the Goldman Sachs US Financial Conditions Index. Data sourced from Bloomberg.

All investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

Past performance is no guarantee of future results.

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