Is Emerging Markets October Outperformance Sustainable?

After lagging behind U.S. equities for most of the year, emerging market (EM) equities outperformed in October, up 4.2% during the month versus 2.2% for the U.S. and 2.6% for developed markets overall. What has led to this reversal – and is it sustainable? In the short-term, EM equity performance can swing wildly, driven by shifts in investor sentiment. EM tends to outperform when investors feel more confident about global economic growth, given that EM economies and markets are high beta plays on global activity and risk appetite. October brought some better news on this front, with economic data showing initial signs of a bottoming in global manufacturing activity. In addition, the announcement of a trade “cease-fire” between the U.S. and China on October 11th helped fuel expectations that the worst is behind us. In order for this recent EM outperformance to continue in the weeks ahead, it is crucial for the upcoming data to continue to improve and for trade tensions not to escalate once again. While the short-term direction of EM equities is still unclear, its long-term destination is not. Emerging markets should continue to provide a substantial economic growth alpha relative to developed markets due to better demographics and a productivity catch-up. This pace of EM economic growth will continue to increase the GDP per capita in many EM countries, which will result in many people entering the global middle class. Consumers have and will continue to emerge in EM. This phenomenon will be particularly strong in EM Asia, from where almost 1.5 billion people are expected to enter the middle class from 2020 to 2030, compared to only 10 million people in North America. Crucially, these individuals will have more disposable income to spend on goods and services. In fact, the spending growth from the middle class will occur at a higher speed than the growth of the population itself. This premium in economic growth should feed through to EM corporate revenue growth as well, translating into higher returns for investors over the next decade. In particular, these trends should benefit EM sectors like consumer discretionary, financials, technology and health care. In the short-term, sentiment waves will continue to rock the EM boat – with turning points incredibly hard to time. In the long-term, these waves end up fading from view and the positive fundamentals determine the destination. With EM equities still cheap relative to its 25-year history, today represents a good opportunity to ensure an appropriate allocation to what is likely to be the next big driver of portfolio returns.