Why Growth Matters in EM, Now More Than Ever

ACTIVE FUNDAMENTAL EQUITY | GLOBAL EMERGING MARKETS TEAM | INVESTMENT INSIGHT | 2017

Executive Summary AUTHORS The global slowdown has not been kind to emerging markets (EM). Though growth is slowing everywhere, it has slowed more sharply in EM economies than in developed market JITANIA KANDHARI (DM) economies. Emerging economies are still growing faster, Managing Director 1 Global Emerging but the growth differential has been narrowing and market Markets Team performance has suffered. Perhaps nothing personifies the negative sentiment towards the asset class more than the recent closing of the “BRIC Fund,” which flourished during the EM STEVEN QUATTRY bull-run that ended years ago.2 Some investors are questioning Executive Director the EM equity asset class as a whole. Yet such extremes in Global Emerging negative sentiment often mark a turning point in an asset class,3 Markets Team and we actually believe that the adjustment in EM could be nearing the final innings. This paper employs our research to answer three of the most pressing investor questions regarding when and how to allocate money to EM. Our answers, in brief:

1. WHEN DO POTENTIAL OPPORTUNITIES EXIST IN THE EM MARKET? When the relative real GDP growth differential between EM and DM is rising. EMs tend to grow faster than DMs at an absolute level, but potential opportunities arise in emerging markets when their GDP growth rates are increasing by more than those in developed markets (or falling by less). For example, EM outgained the MSCI World Index by 165% from 2002-2009 as the growth

1 Throughout this paper we will refer to the “growth differential,” which is simply the difference between the EM aggregate real GDP growth rate and the DM aggregate. For instance, if EM growth is 5% and DM growth is 2% then the differential will be 3%. 2 “Goldman Closes BRIC Fund.” The Wall Street Journal. November 9, 2015. 3 Forthcoming research by MSIM Emerging Markets Equity team. See also: “Breakout Nations” by Ruchir Sharma. Chapter 12, pg. 207 and “How Narendra Modi won by losing ‘Person of the Year,’” by Ruchir Sharma in The Times of India, December 17, 2014. INVESTMENT INSIGHT

differential was rising, however 3. DOES VALUATION MATTER FOR equity asset class, and sentiment is fairly since then, emerging market stocks, COUNTRY ALLOCATION IN EM? depressed at the moment. However, we represented by the MSCI EM Index, Surprisingly, no. Conventional would caution against extrapolating this have underperformed the World Index valuation metrics like price-to-earnings negativity into the future. This is not to 7 by 44% as EM growth has slowed ratio or price-to-book rarely contain say that EM equity headwinds are over, relative to DM.4 valuable information regarding however, we believe the adjustments future equity returns in EM. Value needed are nearing completion, leading 2. DOES GROWTH MATTER FOR COUNTRY as a strategy works generally when us to ask when is it time to buy. ALLOCATION IN EM? Yes. There is a valuation spreads8 are elevated relative camp that argues that growth does to the long term average (one standard We believe that the key driver of EM not matter but bases this conclusion deviation). We believe that valuations performance relative to developed on growth and returns over periods opportunities could eventually arise in markets is the GDP growth differential. as long as a century. Our research EM, but they are very rare and tend Our analysis suggests that the best focuses on periods that correspond to occur during crises.9 At present, opportunities in EM stocks exist when more closely to investor holding although spreads are elevated at 0.65 EM GDP growth is increasing relative to periods, three to five years, and comes standard deviations, we think that DM GDP growth, as this has historically to a different conclusion. We find they do not yet appear extreme.10 On coincided with EM bull markets. Bear that countries with higher real GDP the other hand, we find that currency markets such as the past few years have growth (top quintile) outperform the valuation metrics contain valuable historically coincided with periods when MSCI EM index by an average rate information pertaining to the country EM growth is decreasing relative to DM. of 4.1% a year, while countries with allocation decision in EM equities. In other words, it is not enough for EM lower GDP growth (bottom quintile) GDP growth to be higher than DM GDP underperform by 0.7% a year. The Applying our findings to the more recent growth, because that is nearly always the same holds true in examining Frontier post-crisis period (2009 to 2015), we case. Similarly, in order to remain negative Markets.5 Identifying growth inflection find that high growth, high change in on the EM asset class relative to DM, one points is also of value: countries growth, expensive equity markets and has to expect the growth differential to with the largest acceleration in GDP cheap currencies all outperformed the continue to decrease, not simply stabilize. growth outperform the index by an EM index. Moreover, the fastest growing In the next section we briefly discuss the average annualized rate of 9.6%, while EMs outperformed the lowest growing past, present, and future outlooks for the those with the largest deceleration EMs by 9.3% per year on average, while EM-DM growth differential, arguing for in GDP growth underperform the the countries with the largest growth stabilization in the next 12 to 18 months index by 4.4%, for a spread of 14.0% accelerations outperformed those with and setting the stage for the next phase of annualized.6 Moreover, in periods like the lowest by 7.6% a year. Expensive an increasing differential. the present, when there is only a small equity markets outperformed cheap GDP growth differential between markets by 4.6% a year, and countries The Past, Present, and Potential EM and DM, the variation of returns with cheap currencies outperformed those Future of the EM-DM Growth between the equity markets of different with expensive currencies by 2.6% a year Differential on average. EM countries is significantly higher As a result of tough reforms in the late than normal. In other words, growth is 1990s and its 2001 entry into World When does EM appear attractive? particularly important to EM country Trade Organization, China’s GDP allocation and alpha generation in the The past few years have proved growth accelerated to an average rate current environment. challenging for investors in the EM of 10.8% from 2003 till 2011.11 China

4 Source: Factset. Data as of December 31, 2015. 6 We have replicated this study for MSCI Frontier 8 Defined as the difference in valuation between EM stocks/index throughout this paper refers to Markets which has considerably less history, with cheapest and most expensive quintile of the equity the MSCI EM Index, while DM/developed market data starting in 2002. Nonetheless, our findings markets for different EM countries. refers to the MSCI World Index. for Frontier Markets are very similar: high growth 9 Most recently in 1998 and 2009. 5 outperforms low growth by a considerable spread. We have replicated this study for MSCI Frontier 10 There were a few nuanced differences regarding Source: Empirical Research Partners. Data as Markets which has considerably less history, with of January 2016. data starting in 2002. Nonetheless, our findings the magnitude of returns for other factors, but 11 for Frontier Markets are very similar: high growth broadly the findings were the same. Findings are Source: Haver Analytics. Data as of December, outperforms low growth by a considerable spread. available upon request. 2015. This is not to say China was the only country There were a few nuanced differences regarding 7 Price-to-book is defined as the price of a stock reforming. There were a number of other EMs the magnitude of returns for other factors, but or index divided by the book value per share. which undertook positive reforms in the late broadly the findings were the same. Similarly, price-to-earnings is defined as the price 1990s and early 2000s but this is beyond the divided by the earnings per share. scope of this paper.

2 MORGAN STANLEY INVESTMENT MANAGEMENT | ACTIVE FUNDAMENTAL EQUITY WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER

Another headwind for growth is DISPLAY 1 increasing evidence of “de-globalization” EM relative GDP growth vs. EM relative equity performance as global trade has grown much more 8 100 slowly relative to global GDP than in the past due to a mix of cyclical and secular forces, including the slowdown in China 6 80 and a rise in protectionism across the globe.17 China’s slowdown is hurting EM 4 60 more than DM since many EMs came to rely on China as an export market for 2 40 their goods during the last decade. For example, China is now the top export 0 20 market for 44 countries, more than any other county in the world including -2 0 the U.S.18 This is a fourfold increase 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014 2016 from 2004, when China was the top export market for only 10 countries.19 EM G M G LS China’s import content of exports is now MSI EM E I MSI I RS declining and the country is no longer Source: Factset. Data as of December 2015. expanding as “the assembly plant of the world,” so other emerging economies can no longer grow by supplying equipment became the key driver for emerging performance relationship has reversed, and raw materials to China.20 The growth market and indeed global exports with EM equities stocks down -28% slowdown in China has diminished 13 and GDP growth, importing massive while DM equities were up +30%. demand for commodity imports and amounts of commodities from other lowered commodity prices globally. In the years following the 2008 financial EM countries, and equipment mostly This has disproportionately impacted crisis, we find ourselves in a low-growth from the developed countries. Growth in EM economies and equity markets, world, driven by forces of debt, de- other EM countries rose as well, owing which have a higher representation of population and de-globalization which in part to China’s rise but also to reforms commodities than developed markets. following the Asian and Russian financial are having an outsized impact on EMs. crisis of the late 1990s. Increased capital Many emerging markets have undergone For these reasons, GDP growth in flows also helped to fuel EM growth a massive credit boom over the past five the emerging markets has actually higher as it peaked at 7% of GDP in 2011 plus years, and they now face the payback been slowing more than growth in the from an average of 4% average between of their historically high borrowing developed economies. The GDP growth 14 1980 to 2002.12 in the form of lower future growth. differential between EM and DM peaked Additionally, global population growth in 2007 at 6.1% but has since fallen to Consequently, EM equities (MSCI is declining, shrinking the workforce about 2%, as Display 2 illustrates. For EM Index) experienced strong relative growth rates to historically low levels in reasons we discuss below, we believe that outperformance versus DM (MSCI many countries, and 75 percent of the the majority of the narrowing in the EM- World Index). From January 2001 to decline in global working age population DM growth differential is behind us, and end 2009, EM equities gained nearly growth has been driven by emerging it should stabilize in the near future. +200% while DM returned only +4%. economies.15 Tellingly, 2015 marked the However, in 2010, the growth differential first year in modern history that China’s with DM started to decline, and market working age population actually shrank.16 performance followed. Since then the

12 Source: McKinsey Global Institute. Data as of 17 In 2015, a total of 539 discriminatory trade 19 In 2000, EM exports to other EMs accounted for December 2015. measures were reported to the GTA according to just 7% of GDP, while the US and Europe accounted 13 Source: Factset. Data as of December 2015. the Centre for Economic Policy Research. They for 13%. Now, EM exports to other EMs equates noted: “In no previous year have we found so many to 16% of GDP, while their exports to the US and 14 “The Overlooked Risk of Credit Booms,” MSIM trade distortions so quickly.” “The Tide Turns? Europe has fallen to 8%. Journal, Volume 4 Issue 1 (2014) Trade, Protectionism, and Slowing Global Growth.” 20 World Bank – Global Economic Prospects, 15 Haver Analytics, United Nations. Data as of Q3-2015 CEPR, 2015. “What Lies behind the Global Trade Slowdown?” 16 United Nations. Data as of Q3-2015 18 Source: IMF, DOT, UBS Estimates. Data as of – January, 2015 June 2015.

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forecast 0% for Brazil in the coming few DISPLAY 2 years, a recovery from the recent -4.5% Majority of narrowing in EM-DM GDP growth may be behind us rate, and a conservative -2% for Russia 7.0% which would be a slight improvement 6.1% from the nearly 4% decline in growth in 6.0% 2015. In other words, realistic assumptions 5.0% for growth in EM suggests the differential could stabilize from here at about 1.5% as 4.0% Display 2 shows. 3.0% The risk to this view is that the leverage 2.0% cycle in EM is very extended, something 2.0% we have written about extensively.23 1.0% 1.5% Should a number of EMs face a painful 0.0% disruptive cycle characterized by a negative Start ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 Est. End feedback loop between the financial sector (’01) ’16-’18 and the real economy, we would expect a EM G M G greater narrowing in the differential. ■ I ■ Ideally investors would time their Source: MSIM EME Team calculations, Haver Analytics, IMF. Data as of January 2016. investments in the EM equity asset class to the exact moment growth differentials stopped declining. Yet such exact timing One key reason is that, barring a disruptive index to the MSCI World Index is back can prove difficult in practice. We would financial crisis, China’s growth is gradually to mid-2000s levels.21 Additionally, the simply point out that the headwinds facing slowing to a pace which we think is more price-to-book ratio of EM in aggregate EM are playing out now, and we think we consistent with its income level. Our is now trading at nearly a 40% discount are nearing the final innings. We believe team has maintained a very cautious to MSCI World, as it was in the early that once growth differentials stabilize, so stance on China and economies exposed 2000s.22 On the economic front, the EM too will the relative underperformance of to the country due to the numerous current account, even excluding China is EM, and attempting to time one’s entry overhangs in the Chinese economy such now in surplus. EM currencies outside of into EM equities could prove to be a costly as overinvestment, an unprecedented China have adjusted significantly and our exercise for investors. credit boom, and a shrinking working age measure of EM real effective exchange population. While there is still a widespread rates ex-China is at the lows last seen in For example, a $10,000 investment into belief by many that Chinese authorities the early 2000s, in part driven by the MSCI EMs at inception in 1988 would can order the economy to grow at whatever fall in commodity prices and the hit to have grown to over $72,000 by end-2015, rate they wish, even this faith has taken commodity currencies in EM. yielding an annualized rate of return of a severe hit of late. Once China’s growth 7.4%. Yet if an investor missed only the Given these adjustments, we revisited adjusts lower and there is some resolution 10 best months over the past 27 years, the our forecasts for growth in EM. It now to the debt overhang, the EM-DM growth amount falls to roughly $18,000 (a 2.2% appears to us that the majority of the EM differential should stabilize. annualized return). If an investor missed growth differential narrowing is behind only the twenty best months, they would Outside of China, there have been a us. Even if we assume growth of 5% for have lost money. The initial $10,000 in number of fundamental adjustments China, this surprisingly does not lower the 1988 would have fallen to about $6,000 in the EM equity asset class and EM EM-DM growth differential very much. for an annualized return of -1.8%.24 While economies over the past few years. Part of this reflects the significant decline we would not entirely dismiss broad On a number of key metrics, we are in the differential already experienced, market timing, the message to us is clear: starting to see some similarities with the over 4%. Yet, this is also because we also when things begin to look relatively more early 2000’s when EMs were adjusting forecast a recovery in growth to very attractive, missing out on the exact timing following a serial crisis phase. The relative low rates for a few key EMs currently of a market bottom can prove costly. performance of the MSCI EM Equity experiencing recessions. For example, we

21 Source: Factset. Data as of January 2016. 23 “The Overlooked Risk of Credit Booms,” MSIM calculations, Factset. Data as of December 31, 2015. 22 Source: Factset. Data as of January 2016. Journal, Volume 4 Issue 1 (2014) For illustrative purposes only. It is not possible to 24 Morgan Stanley Emerging Market Equities invest in an index.

4 MORGAN STANLEY INVESTMENT MANAGEMENT | ACTIVE FUNDAMENTAL EQUITY WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER

Does growth matter in EM? DISPLAY 3 Country Factor Matters Much More in EM than DM Though the EM equity asset class is starting to look relatively more attractive, MSCI World Index Percentage Contribution of Style, Industry and Country we believe that a passive investment in the 100% asset class could lead to diminished returns in EM. In contrast to the developed equity 80% markets, the “country factor” dominates returns in emerging markets. In fact, the 60% country risk factor contribution to total returns in MSCI EM has averaged 67%, 40% nearly double the amount for the MSCI World Index as Display 3 illustrates. 20% Moreover, periods marked by a narrowing growth differential between EM and DM 0% correspond to an increased contribution 12/97 12/99 12/01 12/03 12/05 12/07 12/09 12/11 12/13 9/15 from the country risk factor, as Display 4 S I indicates.25 We are now in a low growth world and the GDP growth differential 100% between EM and DM has narrowed substantially this decade, as compared to 80% the past decade. As a result, we believe that now, even more than before, GDP growth 60% will matter for EM equity investors.

40% Since the country effect dominates in emerging markets, several questions arise: 20% Which factors matter for relative country performance? Should investors focus 0% on economic growth? Do valuations 12/97 12/99 12/01 12/03 12/05 12/07 12/09 12/11 12/13 9/15 matter for relative country performance? S I In short, we find that investing in countries with higher future economic Source: MSCI. Data as of September 2015. growth has the potential to yield strong returns in excess of the MSCI EM benchmark index. Investors who have a DISPLAY 4 robust framework for forecasting future EM country contribution rose during periods of low EM-DM growth differential economic growth prospects may be EM vs. DM Growth Differentials and EM Country Contribution to Risk able to generate significant alpha (above benchmark returns) in the asset class. 90% -2% The claim that economic growth matters 80% 0% for relative country stock market returns is often met with skepticism in the 70% 2% investment community. In fact, our clients and colleagues frequently question 60% 4% the association between GDP growth and equity returns. 50% 6%

40% 8% 12/97 12/99 12/01 12/03 12/05 12/07 12/09 12/11 12/13 9/15 25 There are a number of potential explanations for this, however we would surmise that in times of LS lower growth in EM, investors begin to distinguish R G EM M RS more between those countries with stronger underlying economies versus those which may Source: MSCI, Haver, IMF. Data as of June 2015. suffer more as EM growth slows.

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DETAILED METHODOLOGY For our sample, we included all countries which were in the MSCI Emerging Market index in any given year, including those which are no longer members of the index in order to prevent survivorship bias. While previous studies have focused solely on developed markets, or a mixture of developed and emerging markets, we chose to isolate emerging markets simply because this is the asset class we are most interested in as EM equity investors, but also because combining EM and DM indices could potentially skew the results for a number of reasons.26 While other studies on growth and emerging market equity returns use a longer time horizon, stretching back to the 1970s or earlier, we began our study at the inception of the MSCI Emerging Market index in 1988. We chose this starting point since the emerging market equity asset class was much less accessible to international investors prior to this period. Therefore it is possible that high returns prior to 1988 could skew the results. In order to evaluate different factors (listed below) we used a quintile approach as is common in the literature. We report the returns of the top quintile (80th percentile) versus the bottom quintile (20th percentile). For example, using the real GDP growth factor for illustrative purposes, we report the returns from investing in the countries which will grow faster than 80% of all countries and compare it to the returns of the countries which will grow slower than 80% of all countries. Since our sample covers twenty two countries on average in any given year, this means that we compared the four fastest growing countries to the four slowest growing countries. Note that our findings are robust to other measures of “high” and “low” beyond the quintile approach. To measure performance, we used the total return indices of MSCI EM countries at the annual frequency and calculate the three-year compound annual growth return relative to the MSCI EM benchmark index. We perform this exercise each year. We then average the three year compound annual returns for countries in the top quintile of a given factor and compare it to the average of returns for countries in the bottom quintile. For example, using the average GDP growth factor for illustrative purposes, in December of 1990, we calculated the top quintile and bottom quintile of average GDP growth rates for all EM countries through the years 1991-1993. We then calculate the three year compound annualized equity returns relative to the EM index over the period 1991-1993 for both the high and low growth countries (top and bottom quintile). This is repeated each year over our period of study (1988-2014). We then average the returns of the high and low growth countries for all years. The factors studied included average coincident real GDP growth, the change in the average coincident GDP growth, a measure of equity valuations and a measure of currency valuation. A full description of each variable is available upon request.

A series of papers by Jay R. Ritter27 (2005, argue that the long-term nature of Ritter’s that over shorter time horizons, “There is 2012) provides the most well-known analysis actually underestimates the ample evidence that unexpected changes refutation of any relationship between usefulness of economic growth and equity in economic growth affect stock prices.”30 GDP growth and equity returns. Ritter returns for a typical long-only investor studies GDP growth and equity returns in equities. Investors do not set out to For these reasons, we decided to over the very long term and concludes: predict annualized economic growth in empirically test the relationship between “the cross-country correlation of real a given country over the next 100 years, economic growth and relative equity stock returns and real per capita GDP and then invest their money accordingly returns in a study of our own. growth over 1900-2002 is negative.”28 In for the next century. Instead, their time other words, “investors in 1900 would horizon is much shorter—around three to Methodology actually have been better off investing…in five years—and as a result, such investors For our sample, we included all countries countries with slower per capita growth.” might draw very different conclusions which were in the MSCI Emerging While such long-term historical analysis about the relationship between growth and Market index in any given year.31 We is laudable—we utilize similar data equity markets than that offered in Ritter’s began our study at the inception of the ourselves when applicable—we would research.29 In fact, Ritter himself concedes MSCI Emerging Market index in 1988.

26 For instance, perhaps the economic growth models the link between GDP growth and equity returns. we have found that some countries such as Mexico of EMs are such that the relationship between 27 Jay R. Ritter is the Joseph B. Cordell Eminent whereby, despite low GDP growth, equity returns growth and equity returns is different from that of Scholar in the Department of Finance at the have tended to be high due to the oligopolistic DMs. An example would be the rapid industrialization University of Florida and a frequent publisher on nature of the economy. Despite these observations, growth model of China and other EMs historically economic topics. we view these as the exceptions, not the rule. which leads to high GDP growth, but low equity 30 28 “Economic Growth and Equity Returns” Jay R. “Economic Growth and Equity Returns” Jay R. returns for shareholders. Similarly, it is also possible Ritter, University of Florida, Department of Finance, that the observed weaker corporate governance in Ritter, University of Florida, Department of Finance, Insurance and Real Estate; November 1, 2004. EFA Insurance and Real Estate; November 1, 2004. EFA emerging markets relative to DMs leads to lower 2005 Moscow Meetings Paper. returns as company managers may expropriate 2005 Moscow Meetings Paper. 31 profits. Combining both EMs and DMs in the sample 29 We should note that we find merit in many other We included countries which are no longer may distort the link between GDP growth and facets of his papers. For instance we have always members in the MSCI EM index so as not to subject equities for someone interested only in the EM discounted equity returns in countries such as China our results to survivor bias, including Argentina, equity asset class. Finally, as shown above, country where we believe their GDP growth is fuelled Israel, Jordan, Morocco, Pakistan, Portugal, Sri effect appears to matter more in EMs than in DMs. by questionable investment and associated with Lanka, and Venezuela during the years in which Therefore, including DMs with EMs may understate dilution of existing equity shareholders. Similarly, they were members of the MSCI EM Equity index.

6 MORGAN STANLEY INVESTMENT MANAGEMENT | ACTIVE FUNDAMENTAL EQUITY WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER

In order to evaluate different factors DISPLAY 5 (listed below) we used a quintile approach High Growth Countries Outperformed, Low Growth Countries Underperformed as is common in investment research literature. We report the returns of the 5.0% top quintile (80th percentile) versus the th 32 4.0% bottom quintile (20 percentile). 4.1% 3.0% To measure performance, we used the total return indices of MSCI EM 2.0% countries at the annual frequency. We 1.0% chose a three-year period for our time horizon since we think it more closely 0.0% -0.7% corresponds to the holding period for -1.0% most long-only investors in contrast to long periods, which can distort the -2.0% link between GDP growth and equity G L G returns.33 We then calculated the three- year compound annual growth return Source: MSIM EME Team Calculations, Factset. Average three-year annualized return relative to MSCI EM Index. Data as of December 2015. relative to the MSCI EM benchmark index. Our reported returns throughout this paper can then be interpreted as December of 1990, we assume one knows example, in December 1990, we are outperforming the EM index (if positive) which countries will grow the fastest over taking the difference in average GDP and underperforming the index (if the next three years (1991 to 1993) and growth from the three years prior (1988 negative). The factors studied included which countries will grow the slowest to 1990) and the three years in the future average real GDP growth, the change and then invest accordingly such that we (1991 to 1993) and then calculating the in the average GDP growth, a measure report the returns from 1991 to 1993. returns from 1991 to 1993. As such, of equity valuations, and a measure of this factor will capture which countries currency valuation. We found that high growth EMs have saw the largest acceleration (or smallest outperformed the MSCI EM index by an deceleration) in growth and which had Results* average of 4.1% a year, while low growth the largest deceleration (or smallest HIGH ABSOLUTE GROWTH MATTERS EMs underperform the MSCI EM index acceleration) in growth. Interestingly, the by 0.7% a year as Display 5 illustrates.35 First, we tested for the impact of high return dispersion between high changes in GDP growth and low changes in and low GDP growth by following HIGH CHANGE IN GROWTH MATTERS the top and bottom quintile approach GDP growth is even higher than the Next we examined the impact of the described above. Note for GDP growth rate of GDP growth we discussed prior. change in GDP growth on relative we are assuming accurate foresight into In other words, if it can be achieved, returns. Here we are interested in the future GDP growth.34 In other words, in accurate foresight about which countries change in the average growth rate. For will witness the highest change in their

32 In addition to testing the top and bottom quintiles rates. Specifically, one would need to forecast only findings hold if we change the starting point to the (80th/20th percentiles) which we report in the the four fastest growing countries over the next MSCI inception in 1988 as high growth countries paper, we also tested the top and bottom quartiles three years and the four slowest growing countries outperform low growth countries by a spread of (75th/25th percentiles), the top and bottom deciles over the coming three years. 3.7% a year on average. th th (90 /10 percentiles), and above or below the 35 Note that these findings span the period from * For illustrative purposes only. Results are th median (above 50th percentile vs. below 50 1992 to 2014. We chose 1992 as a starting point hypothetical in nature, based on the Emerging percentile). In all cases, investing in high growth because it marked the year many large countries Markets Equity (EME) team’s analysis and led to higher returns, although the magnitude entered the index such as China, India, South Africa, calculations as described. Results are not of the returns vary slightly depending on which Poland, Colombia and Peru, creating a larger and indicative of the historical or future performance measure one uses. more robust sample size. That said the findings hold of any specific investment. Hypothetical results, 33 We report the three-year holding period returns if we change the starting point to the MSCI inception which are created with the benefit of hindsight, in the paper, but our findings are robust to horizons in 1988 as high growth countries outperform low have inherent limitations. They were not of two years and five years as well. In other growth countries by a spread of 3.7% a year on produced under actual market conditions and words, using a two or five year periods does not average. 29 Note that these findings span the cannot completely account for the impact of significantly alter our findings in any way. period from 1992 to 2014. We chose 1992 as a financial risk of actual investing. Furthermore, 34 Note that one needn’t be able to accurately starting point because it marked the year many large indexes used are unmanaged, are listed in U.S. forecast the exact GDP growth rates to the second countries entered the index such as China, India, dollars, assume the reinvestment of dividends decimal for every country. Rather one simply needs South Africa, Poland, Colombia and Peru, creating and do not include fees or expenses. It is not to forecast the relative order of EM country growth a larger and more robust sample size. That said the possible to invest directly in an index.

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growth rate over the coming three years earnings for various firms. Changes in do not increase at the same rate giving a as compared to the prior three years is GDP growth correlate well with earnings double boost to profits. very valuable.36 growth due to “operating leverage” in EM. In other words, as headline growth In short, a high absolute growth rate We found that the top quintile of the slows to take one example, profits take a along with a high change in growth rate change in GDP growth outperformed by double hit: first because of the slowdown may be the best combination for relative 9.6% a year, while the bottom quintile in revenue and second because of the outperformance of a country. underperformed by 4.4%. high fixed operating and capital costs in EM. The opposite happens in periods of ACADEMIC LITERATURE ON GROWTH AND One reason why the change in growth acceleration in growth: profits rise due STOCK MARKET RETURNS delivers a wider return dispersion is likely to higher revenue growth, yet fixed costs Our findings are similar to a study by due to its impact on profit margins and Elroy Dimson, Paul Marsh and Mike Staunton.37 Using data on 85 EM and DM countries going back to 1972, they DISPLAY 6 found that a clairvoyant GDP forecaster GDP Accelerations Substantially Outperformed, GDP Decelerations would be able to generate “far higher Underperformed annualized returns” by investing in the 12.0% “equities of economies that are going to 10.0% have high growth over the years ahead” as opposed to “buying into economies that 8.0% 9.6% are going to suffer poor growth,” over 6.0% one, three, and five year holding periods. 4.0% They also found that the higher the 2.0% future GDP growth, the higher the future 0.0% returns. Dimson et al found no evidence -2.0% of small or large country premium, so the -4.4% overriding influence of expected GDP -4.0% growth is not altered by country size, -6.0% whether in EM, DM or frontier markets. L G A L G To evaluate portfolio performance, they Source: MSIM EME Team calculations, Factset. Average three-year annualized return relative to MSCI looked at total returns drawn from lowest EM Index. Data as of December 2015. growth, middling growth and highest growth countries. The display below shows five-year annualized returns from selecting DISPLAY 7 markets that are destined to experience Five-year annualized return on markets sorted by real per capita GDP high and low growth in GDP after the growth in the future, 1972-2013 portfolio undergoes investment. The 35.0% lowest growth countries yielded only 4% annualized returns over five years and the 30.0% highest growth countries yielded 29%. 25.0% 29% In addition, Dimson, Marsh and Staunton 20.0% found that portfolios based on high GDP growth over the past do not perform well. 15.0% 17% Pure extrapolations from the past do 10.0% not lead to outperformance historically. Lowest growth in the past and highest 5.0% 4% 0.0% 36 Past performance is no guarantee of L M future results. 37 Source: Returns from 1972 – 2013. Credit Suisse Global Investment Returns yearbook 2014, Elroy Returns from 1972 to 2013. Credit Suisse Global Investment Returns yearbook 2014, Elroy Dimson, Dimson, Paul Marsh, Mike Staunton using data from Paul Marsh, Mike Staunton using data from Barro and Maddison. Data as of December 2013. Barro and Maddison.

8 MORGAN STANLEY INVESTMENT MANAGEMENT | ACTIVE FUNDAMENTAL EQUITY WHY GROWTH MATTERS IN EM, NOW MORE THAN EVER

expectations of future growth yielded the EM country indices tended to outperform returns of cheap countries, suggesting the best hypothetical investment results. the index by a similar magnitude. In median is a more appropriate measure. If other words, there is no dispersion among we compare the median returns of cheap DO VALUATIONS REALLY MATTER IN EM returns based on cheap versus expensive, vs. expensive countries, we found that the COUNTRY ALLOCATION? calling into question its usefulness. median cheap country underperformed by We found that on average, there is little Specifically, the average outperformance 0.5% a year, while the median expensive evidence that cheap valuations are a of cheap countries was 2.4% a year, while country outperformed the index by 1.3% compelling reason to buy stocks.38 We the average outperformance of expensive a year. Surprisingly, this suggests that discovered that both very cheap (bottom countries was 2.5% a year. Interestingly, expensive markets tend to outperform quintile) and very expensive (top quintile) unlike with other factors we tested, we cheap markets. found a lot of variation in the average VALUATION SPREADS Value may work as a strategy for country DISPLAY 8 allocation when valuation spreads Annualized returns of portfolios sorted by real per capita GDP growth in (differences in valuation between cheapest the past and future, 1972-2013 and most expensive quintile of markets) 35.0% are well above average, or one standard deviation. This typically happened during 30.0% crises episodes such as 1997.39 Relative 29% returns of value in such cases were better 25.0% for about two years after the episodes. 24% 20.0% We believe that valuation opportunities can occur in EM, but they are very 15.0% 15% rare and happen only during crises. As 10.0% an EM investor, we consider betting on value when we believe the odds are 5.0% stacked in our favor. When valuation 0.0% spreads are above average, we start paying L close attention to value but only when they get to one standard deviation (SD) above average do we reasonably believe Returns from 1972 to 2013. Credit Suisse Global Investment Returns yearbook 2014, Elroy Dimson, that there may be a value opportunity Paul Marsh, Mike Staunton using data from Barro and Maddison. Data as of December 2013. emerging. At the moment, they are rising and stand at 0.65 SD above average.40

DISPLAY 9 While cheap valuations tend not to work No Evidence that Cheap Countries Outperform Expensive Countries for equity market country allocations, we found that currency valuations 3.0% do offer some valuable information. 2.5% A number of studies have suggested 2.5% 2.0% 2.4% that an overvalued currency is often a sign of future real economy troubles.41 1.5% 1.0% 1.3% 0.5% 38 Defined as bottom quintile of the price-to-book value z-score (5-year). We tested other valuation 0.0% metrics, such as dividend yield which is favored -0.5% by many such as Ritter, but found similarly that -0.5% expensive outperformed cheap. -1.0% 39 Empirical Research Partners. Data as of E December, 2015. 40 Source: Empirical Research Partners. As of ■ A ■ M January 22, 2016. 41 Dornbusch, Godfajn and Valdes (1995), Kaminsky, MSIM Calculations, Factset. Average three-year annualized return relative to MSCI EM Index. Data Lizondo and Reinhart (1998) and Gourinchas and as of December 2015.EM Index. Data as of December 2015. Obstfeld (2012) are a few such papers.

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DISPLAY 10 Currencies Contributed One-Third of MSCI EM Total Returns on Average

90% 80% 77% 70% 67% 62% 60% 56% 56% 57% 57% 46% 50% 43% 42% 45% 37% 37% 40% 33% 36% 30% 25% 25% 19% 21% 20% 16% 17% 16% 12% 11% 13% 9% 7% 10% 3% 0% ’88 ’89 ’90 ’91 ’92 ’93 ’94 ’95 ’96 ’97 ’98 ’99 ’00 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15

Source: MSIM Calculations, Factset. Data as of December 2015.

As such, currencies play a vital role in the “cheapest” (or bottom quintile) real returns. Over the medium- to long run, any EM country allocation analysis. effective exchange rate led to an average dollar GDP growth appears to drive We have found that since inception in annualized return of 4.5% above the EM market earnings. 1988, EM currencies have accounted for index. Investing in “expensive” currencies one-third of the annual total returns of underperformed the EM index by about Display 12 shows stock market returns the MSCI EM index (denominated in 1% a year on average. led forward 6 months and CAGR of USD) as Display 10 illustrates. While nominal GDP for each country since there are many different ways to account We have shown how real GDP growth they were introduced in the MSCI EM for currency valuation in the literature, and currency matters for EM investing, (ex-China) Index. Plotting the average we chose one of the simpler metrics for and that valuations may have less of all the annual returns and the average illustrative purposes: the real effective predictive power than widely believed. of all the GDP growth for each country exchange rate deviation from its 5-year It’s also worth pointing out how nominal you see that relative stock market returns average. We then calculated the top and GDP—GDP growth including the are associated with relative nominal bottom quintiles of this variable. We boost from inflation and the exchange GDP growth. Reasonable predictions of found that investing in countries with rate—coincides with nominal country real growth and assessments of currency valuation are integral to our top- down process.

DISPLAY 11 Performance Post Global Countries with Cheap Currencies Outperformed, Expensive Currencies Financial Crisis Underperformed Our study covers the EM equity class 5.0% since the inception of the MSCI EM index in 1988. However, the curious 4.0% 4.5% reader will surely wonder whether our 3.0% findings track for the more recent post- crisis period. Display 13 illustrates how 2.0% applying our findings from 2009 to 2015 1.0% would have performed and reiterates our key findings from above. Have the 0.0% highest growth countries on average -0.9% -1.0% outperformed the MSCI EM Index? Accurate forecasts for the highest and -2.0% lowest growing countries from 2009- REER E REER 2015 would have been very valuable. The return spread between the highest Source: MSIM EME Team calculations, Bruegel, Haver, Factset. Data as of December 2015.

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Summary DISPLAY 12 Nominal GDP growth (x axis) and nominal stock market returns (y axis) Welcome to the low growth world, characterized by debt, de-population, and 30% I de-globalization. The bar for economic success likely needs to be lowered for 25% T E countries across all income categories. In M an environment marked by lower growth, 20% R the ability to spot countries which are 15% R likely to grow the fastest becomes all the T I more important and during periods in S A M 10% M which the EM-DM growth differential is low, the variation in returns between E 5% T different EM countries rises.

0% If history is any guide, our analysis 5% 6% 7% 8% 9% 10% 11% 12% 13% 14% 15% indicates that EM investors with a G robust framework for distinguishing between the fastest and slowest growing Source: Haver Analytics, Factset. Data as of December 2015. countries, in addition to spotting growth accelerations, may be able to outperform by a substantial degree.42 Furthermore, as DISPLAY 13 we have discussed, currency valuation is a Average Annualized Returns Relative to EM Index (2009 to 2015) vital component of the country allocation process in EM, while equity valuation G 2.6% only seems to matter at extremes. 2.3% G The year 2016 is likely to be a crucial one E E M 2.0% for EM as the economic and financial 0.4% adjustment for many countries appears to be entering the final stages. In this L G -6.7% respect, China, of course, outweighs all L G -5.3% other countries in EM and we need to gain greater clarity on their currency and E M -2.6% growth policy, in addition to how they E -2.2% intend to handle the debt overhang before we turn very positive. -8% -6% -4% -2% 0% 2% 4% That said, the EM-DM GDP growth Source: MSIM EME Team calculations, Factset. Data as of December 2015. differential, which tends to correlate well to EM-DM relative equity and lowest growing countries was for a spread of 7.6% a year. Countries performance, has already narrowed 9.3% per year on average as the highest with “cheap” equity markets have significantly. Correspondingly EM has growers outperformed the MSCI EM underperformed the index by 2.0% a underperformed DM equities for the index by 2.6% a year, while the lowest year on average in the post-crisis period, past six years or so. Going forward, growth EMs underperformed the index while the “expensive” equity markets have any incremental narrowing will pale by 6.7% a year on average. Countries outperformed by 2.6% a year. Finally, in comparison to the decline we have which had the largest change in GDP “cheap” currencies slightly outperformed already witnessed. The case for increasing growth outperformed by 2.3% a year by 0.40% a year on average, while allocations to EM relative to DM is more on average over the 2009-2015 period, “expensive” currencies underperformed compelling today than at any point since while those with the lowest change in by 2.2% a year, for a spread of 2.60%. the global financial crisis. growth underperformed by 5.3% a year,

42 Past performance is no guarantee of future results.

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About the Authors JITANIA KANDHARI Managing Director Jitania is head of macroeconomic research on the Global Emerging Markets Equity team focusing on global analytics, country and thematic research. She joined Morgan Stanley in 2006 and has 17 years of investment experience. Prior to joining the firm, Jitania was an emerging markets consultant at GMO. Previously, she was an associate vice president in private banking at ABN Amro, an associate vice president in securities brokering and investment banking at Kotak Securities, and a manager at First Global Securities. Jitania received a B.Com. in advanced financial and management accounting and an M.M.S. in finance, both from the University of Bombay.

STEVEN QUATTRY Executive Director Steven is an analyst on the Global Emerging Markets Equity team, focusing on global macro-economic and thematic research. He joined Morgan Stanley in 2011 and has nine years of investment experience. Prior to joining the firm, Steven was an analyst at Panda Global Advisors, concentrating on economic and investment research. Previously, he was in the financial management program at GE Capital. Steven received a B.A. in finance from the University of Florida and an M.A. in international affairs, with a focus on international economic policy, from Columbia University.

About Morgan Stanley Investment Management43 Morgan Stanley Investment Management, together with its investment advisory affiliates, has 594 investment professionals around the world and approximately $417 billion in assets under management or supervision as of September 30, 2016. Morgan Stanley Investment Management strives to provide outstanding long-term investment performance, service and a comprehensive suite of investment management solutions to a diverse client base, which includes governments, institutions, corporations and individuals worldwide. For more information, please visit our website at www.morganstanley.com/im. This material is current as of the date specified, is for educational purposes only and does not contend to address the financial objectives, situation or specific needs of any individual investor.

43 Source: Assets under management as of September 30, 2016. Morgan Stanley Investment Management (“MSIM”) is the asset management business of Morgan Stanley. Assets are managed by teams representing different MSIM legal entities; portfolio management teams are primarily located in New York, Philadelphia, London, Amsterdam, Hong Kong, Singapore, Tokyo and Mumbai offices. Figure represents Morgan Stanley Investment Management’s total assets under management/supervision.

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This material is for use of Professional Clients only, except in the U.S. There is no guarantee that any investment strategy will work under all where the material may be redistributed or used with the general public. market conditions, and each investor should evaluate their ability to invest The views and opinions are those of the author as of the date of publication for the long-term, especially during periods of downturn in the market. Prior and are subject to change at any time due to market or economic conditions to investing, investors should carefully review the strategy’s / product’s and may not necessarily come to pass. Furthermore, the views will not be relevant offering document. 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