KEY TAKEOUTS

• The persistent outperformance of developed markets has raised concerns about inflated valuations and potential overheated conditions.
• Tech giants have undeniably driven the markets, and their valuations have reached lofty heights.
• Starting valuations matter in the market.
• Investors should be turning their attention towards emerging markets, which currently present appealing valuations and may be on the brink of a performance surge.

Every year, South Africa endures the annual spectacle of parliament’s opening, akin to a British tradition often dismissed as a mere fashion show for politicians. But it is the subsequent Budget Speech that truly grips the nation’s attention.

The 2022 Budget Speech in particular surprised many with an amendment to Regulation 28. Initially met with disbelief, the new landscape is forcing investors to adapt. While the 45% offshore investment limit expands opportunities, it also introduces complexity, in terms of where investors look for additional offshore opportunities. Are developed markets the best place to allocate, or should local investors be considering emerging markets in their diversification approach?

Diverging paths: developed and emerging market cycles

The allure of high returns has driven investors towards developed markets, particularly the US, in recent years. However, the persistent outperformance of these markets has raised concerns about inflated valuations and potential overheated conditions. Given the cyclical nature of markets, investors need to rebalance their portfolios and consider the other attractive opportunities offered by emerging markets.

A famous consultant Peter Drucker once said, “The future is unknown and unknowable.” Directing this adage to the investment industry, which thrives on forecasts and data-driven insights, the reality is that often these predictions rarely live up to the conviction with which they are made. This further drives the point that investment managers should not focus on forecasts, but adapt because the world is unpredictable.  

Given that there is so much uncertainty in the market, we ought to ask ourselves, what reality is the world adapting to?

Looking back to the US years of outperformance

The year 2009 marked the bottom for US markets, but it certainly didn’t feel like it then. Markets had just crashed in 2008, and the word “contagion” was on everyone’s lips. Large banks failed, and those that did not were on the brink of collapse, needing government intervention. Billions had been added to the market in the form of stimulus, and the world was in panic and fear.

Interestingly, traditional sectors were struggling, but the tech industry showed some resilience, though it was far from being the dominant force it is today. The emergence of giants like Amazon Web Services (AWS), Uber and Facebook was still in its infancy, and their potential to reshape industries and markets was largely uncharted territory. These companies went on to experience explosive growth, capturing investor enthusiasm and propelling the broader market upward. Factors including declining interest rates, increased venture capital funding and a burgeoning digital economy fuelled this tech-led rally over the last 15 years. As these tech giants expanded their market dominance and delivered substantial profits, investor confidence soared, creating a positive feedback loop that lifted the overall market to new heights.

Looking at Amazon, launched in 2006, no one knew that 2009 would be the key driver of its earnings and share price for the next 15 years. A company that impacted the transportation industry, Uber, was founded in 2009 and transformed how people move around the world. Instagram launched in 2010, and Facebook and Tesla, which were listed in 2012, are other examples of tech innovations that took the world by storm. If you had told someone in 2009 that US tech companies would dominate and drive markets the way they have, you would have been accused of being delusional.

While these tech giants have undeniably driven the markets, their valuations have reached lofty heights. Historical precedents, such as the dot-com bubble, serve as reminders that even the most dominant companies can experience sharp declines. A question on everyone’s mind is, are we nearing the end of this US tech-driven rally?

US equities returned 834% from the March 2009 bottom, while emerging market equities, which had produced stellar returns up to the Global Financial Crisis (GFC), returned 254%. Emerging Markets (EMs) have always promised a lot with their favourable demographics, young population and high growth potential. Yet, they have perennially disappointed, leaving investors unhappy.

Recent experience has not helped, given the performance differential between EMs and developed markets (DMs). But it doesn’t mean that opportunities do not exist within EMs.

So is there a case for Emerging Markets?

Starting valuations matter in the market. Unlike in 2009, US valuations are high currently, as are the margins. Expectations are also very optimistic.

For EMs, it’s slightly different. Disillusionment from investors has resulted in low expectations and starting valuations. Very little needs to happen to generate returns.

When clients allocate offshore, they often do so through the lens of MSCI ACWI, which has an EM weighting of 11% and a US weighting of 64%. Investing according to this benchmark immediately places investors into a richly priced market and away from a cheap EM. According to the World Bank’s latest published Global Development Horizons Report, China and India are set to become the world’s biggest investors. Together, they will contribute nearly 40% of global investment by 2030.

Let’s explore cyclicality

From 2000 to 2009, US$100 invested in the MSCI EM Index on 1 January 2000, grew to US$261 on 31 December 2009. In contrast, $100 invested in the S&P 500 Index during the same time frame, returned US$75. This period was known as “the lost decade in US equities”, where investing in US equities lost investors’ money for an entire decade. On the other hand, driven by the emergence of China as a commodities consumer, emerging markets thrived.

Now assessing the period from 2010 to 2024, $100 invested in the MSCI EM Index on 1 January 2010, grew to $174 on 30 June 2024 while $100 invested in the S&P 500 in the same period, was $508 on 30 June 2024.

Starting valuations play a critical role in future returns. On 1 January 2000, the starting price-earnings (PE) ratio for the S&P 500 was 24x, while that of the MSCI EM Index was 16x. The expectations priced into the starting valuations in DMs were rich, ahead of the lost decade. At the end of that lost decade, the S&P 500’s PE was a mere 14x, while that of the MSCI EM Index was 12.7x. In the words of Howard Marks, “There’s no asset so good that it can’t be overpriced and become a bad investment, and very few assets are so bad they can’t be underpriced and be a good investment.”

The great returns since 2010 in the US came from rather low valuations. Today’s starting valuations for the S&P 500 are 21x, not too far from the starting valuations of the lost decade. What is evident from this is that, at some point, EMs did better than DMs, for a whole decade. The cyclicality of markets and the importance of starting valuations cannot be overstated. Investors need to be mindful of the current market conditions and adjust their expectations and allocations accordingly.

The recent outperformance of developed markets, particularly the US, has been a great wave to ride for those who managed to get on it. However, as history has shown, markets are cyclical, and the current high valuations and optimistic expectations may not be sustainable in the long term. It has been over a decade of this DM outperformance, and if history is anything to go by, it will likely run out of steam soon.

This is where emerging markets, which have underperformed in recent years, may present an opportunity for investors. With lower starting valuations and more modest expectations, the potential for growth and returns in these markets should not be overlooked.

The DM outperformance can’t be guaranteed indefinitely, because as Peter Drucker pointed out, the future is unknowable.

Where does this place South Africa?

South Africa, as a developing economy, has a currency and market that typically fluctuate alongside other emerging markets. The SA economy and financial system are significantly impacted by China, which is the largest emerging economy. South Africa, as a commodities-producing country, and China’s economic dynamics are closely aligned because it remains the top commodity consumer.

Considering the raised cap of 45% for offshore investments in Regulation 28, investors have several decisions to make. As they boost their offshore investments, it’s crucial not only to look at the returns (with US tech stocks showing impressive performance, as highlighted) but also to be aware of the risks tied to high initial valuations in these tech companies. This leads us to argue for alternatives to offshore investments by turning attention towards emerging markets, which currently present appealing valuations and may be on the brink of a performance surge.