The earnings crunch suffered by emerging markets over the past decade (EM has an Earnings Problem) has been the cause of the dramatic underperformance of the asset class relative to U.S. stocks. Poor EM earnings have resulted from cyclical factors typically affecting all economically sensitive assets, such as commodities and industrial cyclicals. Furthermore, factors specific to the U.S. market have also contributed significantly to the outperformance of U.S. stocks. Most importantly, the flourishing of quasi-monopolistic technology giants (e.g., FAANGs, the Magnificent Seven, and a few others).
The chart below shows USD-denominated earnings for Emerging markets and the three principal U.S. indices: the S&P500, the Dow Jones Industrial, and Nasdaq. The data starts in 1986, which is the year that MSCI launched its institutional index for EM. Not surprisingly, periods of EM outperformance (1986-1996 and 2002-2012) are also periods of relatively strong EM earnings growth underpinned by a cycle of USD weakness. EM dollarized earnings grew in line with the S&P500 from 1986 to 2012. Since 2012, EM earnings have trended down by 7%, while U.S. earnings have increased by 99%, 69%, and 165% for the S&P500, the DJI, and Nasdaq, respectively.
The underperformance of EM earnings since 2012 can be attributed to various factors. First, EM started the period at a level of high unsustainable earnings, buttressed by high commodity prices and a weak dollar. The strong dollar since 2012 alone accounts for 30% of the underperformance. Second, EM had a lower weight in technology stocks, and this sector in EM was hit hard by the Chinese Communist Party’s crackdown on China’s tech sector in 2020. Third, and most importantly, U.S. companies benefited from extraordinary monetary and fiscal expansion over this period, boosting revenues and reducing financial costs.
The extraordinary performance of the dominant U.S. tech stocks and their growing weight in the indices has been the main story driving markets. The great commercialization and financialization of the Information and Communications Technology (ICT) cycle has resulted in a few firms each dominating their niche and very successfully diffusing and monetizing digital technologies not only in the U.S. but worldwide.
Future performance will be determined by how the trends outlined above develop from now on:
- Will the current strong dollar cycle revert?
- Will the U.S. tech sector lose dynamism because of product maturation, regulation, or other reasons?
- Can the extraordinary monetary and fiscal largess be sustained in an era of rising inflation and soaring deficits?