KEY POINTS
1. Factors that have propelled Mag 7 stocks higher—global liquidity, AI optimism and a relatively strong U.S. economy—may face challenges later in 2024.
2. Emerging and frontier markets offer untapped investment opportunity and are cheap relative to the U.S. and other developed markets.
3. Navigating the diverse terrain of emerging markets (EM) requires first-hand knowledge of local economic, political and social dynamics. Active management, including on-the-ground research of local markets, is essential.
Stocks of U.S. mega-cap companies, particularly the so-called "Magnificent Seven" (Mag 7),have surged amid a rush of global liquidity and incredible optimism around the potential of artificial intelligence (AI). Investing in these companies has rewarded many shareholders handsomely, leaving some to question if there's a potential cost in reducing exposure to these stocks.
When weighing this decision, it's essential to consider the factors driving those gains and how likely they are to continue. Several conditions suggest to us that global liquidity, a key factor in driving these stocks higher, may be less supportive in 2024 than it was in 2023.
Global liquidity may weaken
The Bank of Japan's yield curve control policy seems likely to end, and despite China's slowdown, policymakers there aren't signaling stimulus is on the horizon. Moreover, the relatively strong U.S. economy, coupled with AI enthusiasm, helped propel the multiples of these seven stocks—Microsoft, Apple, Nvidia, Alphabet, Amazon, Meta and Tesla—exponentially higher in 2023. Relative political stability in the U.S. has also provided a tailwind for markets. However, a potential U.S. economic slowdown, election uncertainty, or challenges to an AI-dominated future could lead to downside risks for these seven stocks, particularly if all occur simultaneously.
Considering the tailwinds at play, the Mag 7 are likely to represent an outsized exposure in U.S. large cap portfolios, and they now make up 17.5% of the global MSCI All Country World Index (MSCI ACWI) as of March 31, up from 8.3% five years ago. Investors concerned about the potential impact of these risks should consider the unique opportunities in EM.
Attractive relative value in EM
The earnings yield (the inverse of P/E) of MSCI Emerging Markets Index versus the S&P 500 is about as wide as it's been since 2010, suggesting EM could provide value relative to U.S. equities. Emerging markets trading at lower multiples certainly makes sense; EM countries typically have weaker economic institutions than their developed peers and thus require a larger country risk premium. EM countries present a unique opportunity in this regard: as their economic institutions and business environments improve, cash flows are likely to increase, and the country risk premium is reduced.
A differentiated approach to EM equity investing
In our view, an actively managed EM strategy that seeks to forecast improvements in economic institutions and allocate to advancing countries, is well positioned to capitalize on opportunities unique to emerging and frontier markets. Business and economic improvements within individual EM countries are generally less correlated with global markets and more correlated with traditional factors, like value, growth or capitalization, and themes like AI or near shoring. We believe choosing the right countries can lead to excellent returns, surpassing allocating broadly to EM, regional allocations, or even investments in the largest seven U.S. companies. Our strategy for investing in emerging and frontier countries seeks to do exactly that: we take significant country-level bets where our research team believes the economic environment is improving. We identify countries where we see improvements in areas like the rule of law, regulatory environment, soundness of money supply, workforce diversity and the ability to trade internationally. We believe these types of countries are poised to outperform globally.
Exhaustive research from the ground up
Our 50-person team of analysts, traders, quants and portfolio managers focus locally, reading the daily news and communicating with policymakers, companies, opposition leaders and journalists. Collectively, they travel over 100 times a year to do conduct on-the-ground country research. After determining which countries we believe are poised to improve, we build a diversified basket of stocks to capture improvements in country risk premiums, while minimizing exposure to idiosyncratic risks unique to an individual company, market cap, or investment theme.
Bottom line: The Mag 7 have been dominating the returns of U.S. stock indexes in recent years, as well as some global ones. We see potential challenges to global liquidity and other factors that have propelled these stocks higher. Regardless, portfolio diversification is a sound principle. EM and frontier countries offer a wealth of potential value and opportunity for investors to consider relative to developed markets.
Standard Deviation measures how widely individual performance returns, within a performance series, are dispersed from the average or mean value.
S&P 500® Index measures the performance of the large cap segment of the U.S. equities market, covering approximately 75% of the U.S. equities market. The Index includes 500 leading companies in leading industries of the U.S. economy.
MSCI All Country World Index (ACWI) is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed and emerging markets. Source: MSCI. MSCI data may not be reproduced or used for any other purpose. MSCI provides no warranties, has not prepared or approved this report, and has no liability hereunder.
MSCI Emerging Markets Index is an unmanaged index of emerging markets common stocks. Unless otherwise stated, index returns do not reflect the effect of any applicable sales charges, commissions, expenses, taxes or leverage, as applicable. It is not possible to invest directly in an index. Historical performance of the index illustrates market trends and does not represent the past or future performance of the fund. MSCI indexes are net of foreign withholding taxes. Source: MSCI. MSCI data may not be reproduced or used for any other purpose. MSCI provides no warranties, has not prepared or approved this report, and has no liability hereunder.
Past performance is no guarantee of future results.
