The Emerging-Market Rally Is Really Just About Tech Shares
Home-market bias remains one of the great inefficiencies in many portfolios. For example, even though almost half of all U.S.-listed exchange-traded funds are dedicated to foreign stocks and bonds, some 67 percent of their total assets are invested in U.S. stocks and bonds.
There's a relatively simple explanation: American investors are so accustomed to U.S. technology companies dominating the world stage that we think owning Apple/Google/Amazon/Facebook is the same as a well-stamped passport in terms of exposure to international markets. Tech stocks are the single largest weighting in the S&P 500, after all, and they have worked well in 2017.
But the performance of emerging markets this year shows how this home-market bias is a lost opportunity. In dollar terms, the MSCI Emerging Markets Index is up 34 percent, compared with 16 percent for the S&P 500 Index. As it always does, capital has followed performance, with EM ETFs attracting $34 billion in 2017.
How did EM become global market darlings? The answer is not in the old playbook of export-driven growth and rising middle classes. The real driver of performance is one U.S. investors will recognize quite readily. The MSCI EM Index is remarkably tech-heavy, with a 29 percent weighting, topping the S&P 500's 25 percent. To frame this level with some other indexes American investors know well, the Russell 2000’s weighting to technology is 17 percent, which is on par with financials, and the Dow Jones Industrial Average’s 18 percent exposure.
Another point to consider: EM tech stocks with the largest weightings in the index make large-capitalization U.S. tech stocks look downright slouchy, even though the hometown favorites are up an average 30 percent in 2017. Here are the top five holdings in the MSCI EM Index with their year-to-date weightings and performance:
- Tencent Holdings (China): 5.1 percent weighting. Up 99 percent in local currency terms.
- Samsung Electronics (South Korea): 4.7 percent weighting. Up 56 percent in local currency terms.
- Alibaba Group (China, listed US): 4 percent weighting. Up 113 percent in dollar terms.
- Taiwan Semi (Taiwan, ADR in US): 3.7 percent weighting. Up 48 percent in dollar terms.
- Naspers Limited (South Africa). One percent weighting. Up 76 percent in local currency terms.
Despite these gains, EM valuations are still attractive, which is not something you can say -- with a straight face, anyway -- about U.S. equities. Based on recent work by Lazard, EM price-to-earnings multiples stand at 12.6 times forward-year estimates, versus 18 times for the S&P 500. And while EM tech stocks trade at a premium of 14.5 times next year earnings, their expected earnings growth rate is greater than 20 percent.
As much as EM is cheap and working, there are some notable risks. Here are three at the top of the list:
No. 1: The large-cap tech names we noted above have greater influence on the MSCI EM Index than Apple/Microsoft/Amazon/Google/Facebook have on the S&P 500. Total the weightings for the Big Five in EM, and you get 19.6 percent. That's more than the 13.7 percent for the big tech names in the S&P 500. Another way to look at this is that even though the MSCI EM Index has almost 1,000 members, just five essentially represent 20 percent of the benchmark. Any problem with even one or two of these names could put a dent in overall performance.
No. 2: Financials make up the second-largest weighting in the MSCI EM Index, or 23 percent. Add in the tech weighting and you’ve got greater than 50 percent of the benchmark skewed to just two sectors. By comparison, the two largest sectors in the S&P 500 -- tech and financials -- account for just 40 percent of that index, The same groups top the sector list for the Russell 2000, but only represent 34 percent of the total.
No. 3: Well over half, or 56 percent, of the MSCI EM Index is in just three countries: China (27.9 percent), South Korea (15.6 percent) and Taiwan (12.5 percent). India (8.8 percent) and Brazil (6.6 percent) don’t even break into double-digit weightings. That puts the EM index squarely in the middle of the ongoing North Korea nuclear situation. This geopolitical challenge is a far greater issue to the MSCI EM Index than its notionally diversified name would imply.
EM assets looks compelling even after this year’s rally. They are still relatively cheap, the global economy looks decent, and they have their share of homegrown tech sector leadership. Yes, the tech sector concentration risk is an issue, but the way U.S. stocks are working, we may soon have the same problem with domestic stocks as well.
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