EEM - EEM: Will 2024 Be The Year Of Emerging Markets?

2023-12-11 21:28:17 ET

Summary

• Emerging markets have underperformed the S&P 500 for the past decade, but there is potential for a catch-up due to cheap valuations.
• The iShares MSCI Emerging Markets ETF provides easy access to over 1,200 emerging market stocks and is dominated by China, India, and Taiwan.
• As China goes, so goes EM. The Chinese government is expected to implement additional stimulus measures in 2024, which could boost the EEM ETF.

Emerging markets have been a horrible investment for the past decade, with the iShares MSCI Emerging Markets ETF ( EEM ) underperforming the S&P 500 Index by over 10% per year for a decade.

However, looking forward, I am bullish on the fundamentals of emerging markets, as they trade at a steep valuation discount compared to the U.S. Furthermore, the Chinese government has once again vowed to step up its measures to stimulate its moribund economy in 2024. With a modest debt-to-GDP ratio, China has lots of room to stimulate if it so chooses. I rate the EEM ETF a buy.

Fund Overview

The iShares MSCI Emerging Markets ETF tracks the performance of large- and mid-cap emerging market equities. The EEM ETF provides investors easy access to over 1,200 emerging market stocks and can be used to diversify investor portfolios.

The EEM ETF tracks the MSCI Emerging Markets Index ("EEM Index"), a global index that contains leading stocks from 24 emerging market countries: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Kuwait, Malaysia, Mexico, Peru, the Philippines, Poland, Qatar, Saudi Arabia, South Africa, South Korea, Taiwan, Thailand, Turkey and the United Arab Emirates.

The EEM ETF is one of the largest and most established ETFs focused on emerging markets and has almost $17 billion in assets (Figure 1). The EEM ETF charges a relatively expensive 0.69% expense ratio.

Portfolio Holdings

The EEM ETF is a passive market-cap weighted ETF and contains over 1,200 securities in its portfolio (Figure 2).

In terms of geographical allocation, the fund is dominated by China (27.4%), followed by India (17.0%), Taiwan (15.7%), South Korea (12.3%), and Brazil (5.7%) (Figure 3).

Sector-wise, the EEM ETF's largest sector weights are Financials (22.4%), Information Technology (21.3%), Consumer Discretionary (12.9%), Communication (9.4%), and Materials (7.8%) (Figure 4).

EEM's sector allocation has morphed over the years, as the EEM ETF was known as a materials and energy dominated ETF back in the early 2000s when it was initially launched, mirroring the composition of emerging markets in those early years. In more recent years, as technology companies have grown in significance across the globe, the EEM ETF's sector allocation has more resembled that of developed markets, with Information Technology playing a large role (Figure 5).

Currently, EEM's top 10 holdings account for 23% of the portfolio and are dominated by Taiwan Semiconductor ( TSM ), with a commanding 6.6% weight, almost double that of the next largest company (Figure 6).

Distribution & Yield

The EEM ETF is currently paying a 2.3% trailing yield, about 50% higher than that of the S&P 500 (Figure 7).

Returns

Unfortunately, despite above average dividend yields, the EEM ETF has delivered disappointing performance in the past decade. On a trailing basis, the EEM ETF has returned average annual returns of -4.8%/1.5%/1.4%/5.8% over the past 3/5/10/15 years to November 30, 2023 (Figure 8).

This performance by the EEM ETF pales in comparison to the SPDR S&P 500 ETF Trust ( SPY ), which has returned 9.7%/12.5%/11.7%/13.6% respectively over the same timeframes (Figure 9).

Will 2024 Be The Year Of Emerging Markets?

However, if there is one thing that we know for certain in Finance, it is that historical performance does not dictate future returns. Precisely because emerging markets have massively underperformed in the past decade, there is a possibility of a catch-up of emerging market assets if the right macro-economic drivers are in place.

Emerging Markets Are Cheap

For example, if we look at Forward P/E multiples, emerging markets overall are trading at only 11.5x compared to 16.0x for the All Country World Index and 19.2x for the U.S. (Figure 10).

While market returns in any given year are dependent on fundamental drivers like economic growth and interest rates, investors should be aware that starting valuations do matter. Historically , when the starting forward P/E of a market is as elevated as they are for the U.S. (currently >19x), annualized 10-year forward returns have been low to negative (Figure 11).

In contrast, when starting forward P/E's are at 11.5x like Emerging Markets are currently, annualized 10 year forward returns have been fairly attractive.

Emerging Markets Are Not Homogeneous

However, Emerging Markets are not all the same. For example, if we just look at a Forward P/E, we can see that there is a wide dispersion between various Emerging Markets, with China and Brazil trading at a cheap 9.5x and 7.8x Forward P/E, while India is actually more expensive than the U.S. at 20.2x (Figure 12).

As China Goes, So Goes EM

Without a doubt, the most important Emerging Market economy is China, as it contributes over 27% of the EEM ETF. Furthermore, as China's GDP of $19.9 trillion is second only to that of the United States, China has a large influence on the growth of the rest of the world (Figure 13).

With respect to the Chinese economy, 2023 has failed to live up to many analysts' expectations from the beginning of the year. Back in early 2023, Wall Street analysts were expecting a large rebound in Chinese growth as the country exited zero-COVID measures.

However, hampered by the bursting of its real estate bubble, The Chinese rebound in 2023 has been uneven, with official GDP only growing at roughly the 5% target despite repeated Chinese stimulus measures throughout the year (Figure 14).

As we prepare to enter 2024, the Chinese government is once again pledging additional stimulus measures to spur an economic rebound in the new year. According to the Politburo, China will "continue to implement a proactive fiscal policy, which will be moderately strengthened, and implement a prudent monetary policy, which will be flexible, moderate, precise, and effective".

Without specifics, it is unclear how effective the new stimulus measures will be. However, with a debt-to-GDP ratio of only 77%, relatively modest amongst the G20 nations, China certainly has room to provide fiscal stimulus to its economy (Figure 15).

Geopolitics Could Be Wildcard

The biggest risk to China remains geopolitics, as the American government seems intent on stymieing China's efforts to move up the technology value chain by restricting the export of critical semiconductor technologies and equipment. China is not helping itself by its stance on important global issues like the Russia/Ukraine war and a potential conflict over Taiwan.

If China does make overtures regarding Taiwan, the EEM ETF could suffer large losses, as China and Taiwan represent a combined 43.1% of the ETF.

Technicals Remain Bearish For Now

Technically, the ratio between the EEM ETF and the SPY ETF peaked in 2010 and has been in a 13-year downtrend, with no signs of inflection yet (Figure 16).

One big driver behind EEM's relative underperformance has been the strength of the U.S. dollar, which has been in a strong uptrend since 2011. However, with the Federal Reserve potentially finished raising interest rates, momentum on the U.S. dollar could be heading lower, which may provide a boost to the EEM ETF (Figure 17).

Investors should note that the EEM/SPY ratio saw counter-trend rallies in 2016 and 2020, the last 2 times the U.S. dollar weakened.

Conclusion

The iShares MSCI Emerging Markets ETF provides investors with a convenient fund to bet on the performance of emerging markets. Emerging markets have been mired in a decade-long slump against the U.S. markets, with the EEM ETF returning only 1.5% p.a. vs. 11.7% for the SPY ETF.

However, with the Federal Reserve potentially finished raising interest rates, the U.S. dollar looks to have peaked, which may provide support to Emerging Market assets. Furthermore, from a valuation perspective, Emerging Markets are trading at a steep discount compared to the U.S.

For investors with a long investment horizon, I believe investors accumulating emerging market assets at these valuations will be richly rewarded over the coming years. I rate the EEM ETF a buy .

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