Emerging market (EM) equities represent a rich, varied, and underappreciated asset class.

EMs have become the engine room of global gross domestic product (GDP) growth, driving 65% of the world’s economic performance over the last decade.1 Despite this, EM equities remain underrepresented in global indices by market cap. Many investors are structurally underweight due to index composition and a bias towards domestic markets. This is particularly true for EM small caps, which rarely feature into asset allocators' portfolios.

We believe investors who overlook EM small caps are missing out. Here, we explain why.

At an inflection point

EM equities, especially small caps, offer diversification away from developed markets (DMs). The latter is heavily skewed to the US economy and an increasingly narrow band of technology stocks.

Over the last decade, US earnings have driven developed markets’ outperformance. We believe this is changing.

Over the last decade, US earnings have driven DMs’ outperformance. We believe this is changing. We are seeing indications that the US economy is starting to wane. At the same time, EM economies and capital markets are at a macro and micro inflection point. Following ten years of underperformance, fresh drivers are revitalizing equity markets.

One area to highlight is global capital expenditure (CapEx). A substantial part of this spending goes towards purchasing tangible assets produced by EM countries, including computer chips and car engines. After years of underinvestment, capex spending is set to ramp up. This will be driven by nearshoring, the green transition, and a technology revolution.

EMs also look relatively attractive from a macroeconomic perspective. In the US, years of unorthodox policy have left its debt-to-GDP ratio at an eyewatering 112%. This compares with 65% for EMs. In the corporate world, US net debt-to-equity is 77%, while it’s 24% in EMs.2 Many US companies used this debt to fund share buybacks, which helped sustain the US market performance over the past decade. It is unclear what will drive the next leg-up in US performance.

EMs, by contrast, have delivered a prolonged period of fiscal discipline and high real rates. Company balance sheets are robust, and inflation is under control in many nations. Notably, EM central banks are poised to cut rates ahead of their DM counterparts. Brazil and Chile have already pulled the trigger.

Together, we believe these divergent factors will end a decade of consistent US market strength and spur a marked increase in EM earnings.

Reasons to consider

The EM small cap universe is broad, boasting over 2,500 companies with a market cap of under US$5 billion.3 That's nearly twice as many companies as the MSCI EM large cap Index. Small caps are also more diverse by sector and country. Despite this, they represent only 1% of total client allocations, according to eVestment. So, why should investors consider a small cap allocation?

Outperformance potential

EM small caps have an impressive long-term track record (Table 1), historically outperforming EM large caps, global small caps, and numerous DM markets (Chart 1). Since 2021, EM small caps have delivered twice the return of EM large caps. And, while past performance doesn’t guarantee future returns, we believe the economic tailwinds set to blow through EMs should continue to propel this outperformance.

Table 1. Impressive long-term track record

Source: abrdn, FE analytics, Annualized Total Return, December 2023. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Chart 1. Outperformance potential

Source: Bloomberg, January 2024. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

Risk reduction

There's a widely held misconception that EM small caps are highly volatile. However, the universe has lower volatility than DM smaller companies and other regions (Chart 2).

Chart 2. Three-year realized volatility[4]

Source: abrdn, October 2023. Indexes are unmanaged and have been provided for comparison purposes only. No fees or expenses are reflected. You cannot invest directly in an index.

This makes sense. Global ownership of EM small caps is low, while the market is relatively difficult to access. Then there are index weightings. The top ten large cap stocks represent 23.2% of the EM large cap index. This compares with 3.2% of the small cap top ten. As a result, the small cap index is more resilient to swings in global liquidity.

Diversification benefits

As for country weightings (Chart 3), while China dominates the MSCI EM Index, India features prominently on the small cap index. With China and the US at loggerheads, India is benefiting from shifting supply chains and renewed internal investment. This creates good long-term opportunities with less geopolitical risk. On a sector basis, financials make up a large portion of the EM large cap index. By contrast, industrials and real estate firms have the heaviest weightings in the small cap index. These sectors are likely to benefit from increased CapEx spending.

Chart 3. MSCI EM small cap country weights[6,7]

Source: MSCI EM and MSCI ACWI, September 2023. Index weights are subject to change.

Exposure to EM small caps helps EM large cap investors diversify their portfolios and spread investment risk across sectors and the market cap spectrum. For global small cap investors (Chart 3), EM small caps offer exposure to fast-growing markets, such as India, Taiwan, and South Korea.

What’s driving EM small caps?

Several structural themes are igniting EM small caps. First, and chief among them, is nearshoring. This involves companies moving their supply chains closer to their end-consumers. Indeed, US firms are increasingly shifting operations from China to Mexico. Second, a technology revolution is also boosting EM earnings. Third, are the monumental changes are underway to combat the effects of climate change. Industries old and new are being transformed. Many EM small caps are leading the fight in areas like electric vehicles and carbon capture. Lastly, small caps are exposed to EMs’ rapidly growing and increasingly affluent middle class. This cohort has money to spend, bolstering property ownership and consumption. Crucially, EM small caps offer unique exposure to these themes not found in the large cap index.

Final thoughts

After a decade of underperformance, we believe the time for EM equities has arrived. The economic landscape is improving and compares favorably with DMs. EMs are also at the forefront of the major themes that will shape the future, from the energy transition to the technology revolution. EM small caps offer unique exposure to these themes not found in the large cap index.

1 abrdn, MSCI, eVestment, IMF in PPP terms, December 2022.
2 BIS, Jefferies, December 2022.
3 Bloomberg, November 2023.
4 Realized volatility refers to the measure of price fluctuations in a financial instrument, such as stocks, bonds, or currency, over a specified period. It's calculated by using historical price data to determine the degree of variation in an asset's price. Realized volatility helps investors assess the risk associated with a particular investment and is commonly used in financial models and portfolio management.
5 abrdn and MSCI, November 2023.
6 The MSCI Emerging Markets Small Cap Index (MSCI EM SC Index) captures small cap representation across emerging market countries.
7 The MSCI All Country World Index Small Cap Index (MSCI ACWI SC Index) captures small cap representation across both developed market and emerging market countries.

Important information

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