The changing shape of long-term growth in today's emerging markets

Emerging markets (EM) have undergone significant changes in the 30 years since the inception of the MSCI EM Index. Market capitalization has grown from $52 billion in 1988 to $5.3 trillion today,¹ and EM economies’ current share of just over half of global GDP has been forecast to grow to almost 65% by 2022.² According to one projection, the economy of China could surpass the U.S. economy in size before 2030.³

Relative to the size and potential growth of EM economies, the EM equity asset class remains vastly under-represented, making up just 12% of total global market capitalization, as represented by the MSCI ACWI Index.¹ However, this share is predicted to grow to as much as 40% by 2050,³ as EM economies mature, their capital markets deepen, and as domestic savings pools become institutionalized. With deepening capital markets comes a broadening of the range of bottom-up investment opportunities.

As the EM footprint in the global economy and global markets has expanded in recent years, the forces driving EM economic growth have changed. These changes have been especially notable in China, where government reform has helped bring about a shift away from heavy reliance on exports, commodities, and fixed investment. Official policies have stimulated domestic drivers of growth and job creation; technology-based services and consumer-oriented companies are becoming increasingly important, supplanting traditional state-owned enterprises that had long dominated China’s old economy.

Across many EM countries, correlations between equity performance and commodity prices have historically been closely linked, as a result of the important role that commodity extraction industries have played in these countries’ economies. However, this dynamic has been changing in recent years, supported by improved EM government policy frameworks, structural reforms, technological innovation, and the growth of the middle class. In 2007, stocks in the materials and energy sectors of the MSCI EM Index represented a cumulative 32% of the index; in contrast, information technology and consumer discretionary stocks accounted for shares of just 12% and 5%, respectively. A decade later, the financials and information technology sectors represented more than 50% of the index, with consumer discretionary stocks a further 9%, nearly double the 2007 figure. Meanwhile, the cumulative share of materials and energy has fallen to just 15%, less than half of the 2007 figure.¹

In China, the new economy’s success has coincided with the emergence of an increasingly affluent middle class. In 2000, just 4% of China’s urban population was considered middle class—defined as earning $9,000 to $34,000 a year; that figure is expected to reach 76% by 2022.⁴ China’s middle class is not only relatively young, but also willing to spend, with consumption spending growing at a rate of 14% a year. Spending by millennials is growing twice as fast as the cohort aged 35 or older and is expected to account for as much as 53% of total Chinese consumption by 2020, up from 45% today.⁵

Much of this spending is already taking place electronically, creating the biggest single e-commerce market in the world. China now accounts for nearly half of worldwide e-commerce, up from less than 1% a decade ago.⁶ Chinese consumers have enthusiastically embraced new technology through their smartphones, and providers such as Alibaba and Tencent are benefiting from a vast domestic market, largely unencumbered by legacy infrastructure. China’s shoppers have taken quickly to online shopping and digital payments because of the ubiquity of cheap connectivity and the remarkable speed with which associated payment, credit scoring, and delivery logistics have developed.

In India, the government has forcefully driven a digital revolution that has created unprecedented growth in levels of financial inclusion. In 2015, the government launched Digital India, an initiative to upgrade the country’s online infrastructure and electronically provide government services to its population of 1.3 billion. A secure and stable digital infrastructure, including the digitization and modernization of India’s banking and financial systems, has fostered widespread financial inclusion. Within three years of the initiative’s launch, almost 300 million new bank accounts were registered; mobile banking transactions increased by almost five times between 2015 and 2016 and are expected to grow by almost 20% each year to 2021.⁷

Alongside the huge increases in potential online customers, the Indian economy has seen significant growth in financial services. Mobile-only banking and payment services, housing finance, insurance, investment services, and digitalized financial solutions are growing rapidly as a result of the government’s initiative to digitalize the country’s infrastructure, which the private sector has embraced.⁷

With a youthful population and a median age of 28.2 years old, India’s middle class is expected to double to 550 million by 2025. As with China, this is an increasingly affluent middle class that has readily adapted to new technology: 240 million Indians use Facebook, the highest figure for any single country in the world. With much less developed infrastructure, there’s significant potential for growth: 14% of India’s total internet population shops online compared with 64% in China, while its GDP is currently one-fifth of China’s.⁸

The changing shape of the new EM economies and the increasing role of domestic consumption, allied to new forms of technology applications such as e-commerce and internet banking, are fundamentally changing the shape of the investment opportunity across EM. In 2017, broad-based EM earnings acceleration and continued economic recovery served as catalysts that drove the MSCI EM Index to a strong 37.3% annual gain.⁹ However, the first half of 2018 introduced a host of challenges for EM equities broadly, resulting in underperformance of the asset class relative to most developed markets. Despite these recent struggles, our positive view of the long-term drivers of EM economic growth remains intact. We believe the recovery cycle for EM economies remains at a relatively early stage, after a prolonged period (2010–2016) of suppressed economic and earnings growth in the wake of the financial crisis of 2008–2009. Risks to EM equities include geopolitical tensions, such as trade frictions, and the possibility that any potential rise in inflation could trigger an abrupt tightening in monetary policies by the world’s major central banks. However, we don’t believe the ongoing transformation in EM economic growth is merely a distant long-term story for tomorrow’s investor.

Over the longer term, profound structural changes are redefining investment opportunities. The convergence of demographics, government reform, and innovative technology is leading to strong and more resilient domestic EM economies in which a dynamic private sector is playing an increasingly significant competitive role. These trends present investors with a new platform of compelling opportunities, establishing a new and powerful long-term investment case for EM equities.

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1 MSCI Inc., as of 5/31/18.

2 “World Economic Outlook,” International Monetary Fund, October 2016.

3 “The World in 2050,” PwC, February 2017.

4 “Mapping China’s Middle Class,” McKinsey & Co., June 2013.

5 “China’s Middle Class is Exploding,” Business Insider, 8/28/16.

6 “China Eclipses the US to Become the World’s Largest Retail Market,” eMarketer, 8/18/16.

7 “Banking on India: Transformation, Reinvention and the Future of India’s Banking Industry,” IBM, August 2017.

8 HSBC Research, World Bank WDI, as of 9/17.

9 MSCI Inc.