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DOUG By Guest Blogger Doug Rowat

There’s an old Chinese proverb (I guess they’re all old) that says “if you plan for one year, plant rice. If you plan for 10 years, plant trees.” Well, after this disastrous year, emerging market investors are probably pretty tempted to plant nothing. In other words, give up on the region entirely.

And how painful has it been for emerging market investors this year? Well, the MSCI Emerging Market Index is down 16% and the CSI 300, the benchmark for China A-share equities, which has taken the brunt of the punishment, is down 21%.

With commodity prices plunging, Donald “the Tariff Man” Trump taunting China continuously, rising US interest rates and a strong US dollar, both of which are negative for emerging market economies because of their significant amounts of dollar-denominated debt, and an overall risk-off market sentiment at the moment, emerging market equities are easy to hate. But extreme bearish sentiment presents opportunities.

The long-term thesis for investing in emerging markets is well-known but worth repeating. Emerging market populations are young, emigrating rapidly to urban areas and voraciously adopting developed-world technology. For instance, about 58% of China’s population has Internet access, up from only 23% 10 years ago, according to CNNIC. And China has already surpassed the US in total retail sales. Think of what China’s retail sales numbers will look like when it reaches the US’s 89% Internet adoption rate in the coming decade.

As China accounts for roughly 30% of the MSCI Emerging Market Index, it’s also worth focusing on this country’s mind-boggling urbanization rate. In the 1970s, the percentage of China’s population living in urban centres hovered at only the mid-teens. Now it sits at 58%. Yet, with more than 40% of China’s population still living in rural areas, the ‘citification’ trend still has plenty of room to run.

And China urbanization has an incredible trajectory, with rates likely to approach developed-world levels within the next 10 years. The below chart compares China’s historical pace of urbanization to Canada and the US’s—in this race, developed countries have the lead, but China is, effectively, Usain Bolt. The economic advantages of more urbanization are significant: more jobs are created, salaries can ramp-up five-fold, and demand for material goods and housing both rise dramatically.

Urban population (% of total)

Source: United Nations Population Report

So, to think emerging markets are simply going to disappear under the weight of their short-term economic problems is naïve and overly pessimistic. When the MSCI launched its first comprehensive emerging markets index back in 1988 only 10 countries were worthy of representation and encompassed only 1% of the world’s market cap. Today this index includes 24 countries and 11% of the world’s market cap. Emerging market investing is here to stay.

But, from a timing perspective, should investors buy now? Well, valuation is a notoriously poor predictor of entry points, particularly for short-term investors, but regardless, I would still argue that current valuations are compelling. For example, the price-to-book (P/B) differential between the MSCI Emerging Market Index and the S&P 500 is as wide as it’s been in 10 years.

MSCI Emerging Market Index P/B discount to S&P500 continues to widen

Source: Bloomberg

And let’s take a closer look at this spread. Naturally, emerging market equities historically trade at a P/B discount to US equities given their higher risk profile. However, the discount widened to more than DOUBLE its 10-year average (white line below) before contracting in recent months. Given the still-considerable spread, I wouldn’t be surprised to see the discount continue to contract. But if your investment horizon is 10 years or more, then whether to invest now or later amounts to splitting hairs. Emerging markets, simply put, are cheap.

MSCI Emerging Market Index P/B minus S&P500 P/B

Source: Bloomberg. White line = 10-year average

Relatively speaking, emerging markets have had a sub-par past 10 years with the MSCI Emerging Market Index returning 8.7% annually (total return) versus the MSCI World Index up 11.1%. However, a 20-year time frame paints a different picture, with the MSCI Emerging Market Index returning 8.9% annually versus the MSCI World Index returning only 5.4%. If you believe in long-term cycles of under- and outperformance, the next decade could belong to emerging markets.

And, if you had to choose an area to invest in for the next 10 years, given its impressive economic and demographic fundamentals, long-term outperformance and inexpensive valuation, you could do worse than to pick emerging markets. As it stands now, emerging market equities are not being fairly represented in MSCI indices based on their corresponding share of world GDP. It could be argued, in other words, that the market is not giving emerging market equities their proper due based on their global economic contribution:

GDP share and market share for EM

Source: MSCI, IMF

Eventually, emerging markets will rally, likely strongly. And if you’ve decided to abandon this area of the market entirely because of a few threatening Trump tweets, you’ll miss out on the recovery. And you’ll have no one but yourself to blame.

You’ll be reminded of another Chinese proverb: “if your face is ugly, don’t blame the mirror.”

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.

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