The late Sir John Templeton was well-known for saying “the four most dangerous words in finance are ‘this time it’s different’”. This wisdom has provided a lot of value over the years, and his preference for historical analysis has been particularly useful in understanding market cycles in a long-term setting.
However, the other side is that one must also be mindful of the ways markets evolve. This can be demonstrated in a variety of ways, but we have selected emerging markets below as a means of illustrating the dangers of expecting history to exactly repeat itself.
The fact that almost 80% of the emerging market index is from countries that weren’t even investible in 1988 demonstrates how far emerging markets have come. Countries such as China, Russia and Taiwan have opened up and taken a large amount of market share relative to the 1988 exposure which was dominated by Malaysia.
The same issue also applies by industry, with drastic changes notable. Information technology is better known for its U.S. representation, but has been a big mover in emerging markets too and now accounts for 24% of the emerging market index, and 34% in Asian emerging markets. This has evolved from just 5.5% of the emerging market index in the late 1990s, where materials used to dominate the index, having fallen from 16.5% to just 7.7%.
The Earnings Growth Dilemma
Any assessment of the evolution of emerging markets is further confused by a need to be “macroconsistent”. Specifically, the long-run payout growth expectations for financial assets tend to be anchored in reasonable growth expectations for the economy overall. After all, financial assets cannot outperform the economy indefinitely since the asset would ultimately become the economy itself. It is on this basis that we tend to explore productivity type measures as a basis for ‘payout growth’ and can demonstrate the validity of such an approach below using more than a century of U.S. data.
While these long-run trend growth rates examined are closely related in developed markets, there are significant challenges when using the same logic for emerging markets. Specifically, when the economic composition changes over time it gets progressively harder to link such measures.
Take an example like India, where real economic growth is very healthy and will progressively lead to a more affluent middle-class. The link between that economic growth and the growth of corporate payouts could easily break, especially when one also considers issues such as the fight on corruption.
While there are no easy answers to solve such an issue, logic implies that conservatism is warranted and a larger margin of safety is required. To do so, we tend to use sectoral crossover – by assessing payout growth by sector group and applying this to the emerging market composition – as well as qualitative overlay to ensure payout growth rates are as accurate as possible.
