China, other Asian markets are still a better long-term bet than developed economies, so don’t follow the herd
- Patrik Schowitz says recent news may be pushing investors away from emerging markets, but long-term growth trends mean now may well be the time to buy
Watch stock markets patterns long enough and you pick up aspects of human psychology. The term “herding” is one example – the “herd instinct” mentality can cause people to gravitate towards the same or similar securities based almost solely on the fact that others are buying or selling them. Put another way, no one likes to be the first one on the dance floor.
That’s particularly relevant now, as beaten-down Asian markets may be prompting investors following the flow to sell down their holdings. Asian equities have lost more than 15 per cent in the year to date, and domestic Chinese equities have sunk by around 20 per cent – even counting their recent bounce back from even more depressed levels.
But in the face of a painful sell-off, breaking from the herd may be better for long-term financial health. The history of investing teaches that the price you pay when buying an asset tends to have a large impact on your returns. Time after time, when purchasing a stock trading below (sometimes significantly below) its long-term average price, you tend to get back an above-average long-term return. Starting valuations account for as much as 60 per cent of returns over a 10-year horizon.
The problem is that, as humans, it is inherently difficult to go against sentiment and buy an asset when it is cheap.
After the recent weakness, emerging equities now look like reasonable value, trading at a price-to-earnings (P/E) ratio of just over 13 times, compared to a 20-year average of around 15 times, with valuations for Chinese offshore equities (accounting for about a third of the total emerging equities universe) looking very similar.
In contrast, domestic Chinese equities look downright cheap, as they also trade at around 13 times P/E, but have historically averaged closer to 20 times, although a fair valuation today may be somewhat lower. To be fair, developed markets in aggregate also don’t look too expensive, with their current P/E of 18 times roughly in line with history (although US equities do look somewhat pricey).
Beyond valuations, in the long run, it is economic growth, inflation and interest rates that ultimately drive profits, payouts and returns to investors. And importantly, the long-term potential in emerging market equities, dominated by Asia, still looks promising today compared to prospects elsewhere in the world. Returns from most major developed markets, in contrast, will be held back by structurally lower economic growth, mostly due to weak demographics, as well as the higher valuations already mentioned. All these factors are less of a worry in emerging markets.
There are two main drivers of an economy’s growth potential over the long term: the number of people in work (the labour force), and how much each worker produces (productivity).
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In the case of China, it is true that demographics are also worsening, as growth in the number of people working has slowed, but ongoing urbanisation will continue to make more workers available for some time. China also still has plenty of scope to make the workers it has more productive, mainly through better and longer education, providing them with more and better equipment and through catching up to developed economy technology and work practices.
Combining these factors, our long-term capital market assumptions concludes that Chinese economic growth looks set to average around 5 per cent in real terms over the next decade or so, while emerging economies in aggregate should deliver more than 4 per cent, putting them well ahead of that the sub-2-per-cent growth rate in most developed economies.
With support from these fundamentals, emerging equities still look likely to deliver returns of between 8 per cent and 9 per cent over the coming decade, around 3 percentage points higher than for developed economy equities. As markets this year amply demonstrate, that extra return potential does come with higher risk (volatility), but for investors with a long horizon, it is probably still worth it.
Going against the grain is inevitably uncomfortable, but if you can overcome behavioural biases, stomach the volatility and keep a steady eye on the long term, it is possible to avoid the emotional pitfalls that trip up the herd.
Patrik Schowitz is a global multi-asset strategist at J.P. Morgan Asset Management