In the last 15 years, economic growth has been booming across emerging markets (EMs), with China and India generating around 10% GDP growth per year. As investments  poured into these markets, investors naturally assumed that this would feed through into earnings per share (EPS) growth, the main determinant of long-term stock market returns. However, macro growth is not market growth (Figure 1).

Figure 1

The US and China are the best examples of this dynamic. China EPS growth has stagnated while US EPS growth has been exceptional, despite China’s economy growing at twice the speed of the US. 

Index composition and whether underlying companies are reflective of the economy at large can drive disparities. Within the US, growth has been led by the tech sector, which comprises a lower part of the overall US economy compared to its market cap. These large- cap companies have captured more market share compared to small/unlisted companies.

When EPS is diluted by additional company share issuance, it can further exacerbate this misalignment with GDP growth, which has been a significant drag within China. Index rebalancing toward lower-earning companies has also been a factor in China’s lower market returns. Some of the largest EM ex China markets, such as Taiwan, realized outsized returns relative to GDP growth, as large companies generated most of their earnings abroad, not in the country of domicile.

Investment implications

• In the medium term, we believe US companies can continue to outgrow the economy. Current levels of innovation and capex do not signal rotation away from the mega caps, and existing market leadership is likely to remain relatively out of sync with the economy.
• EM ex China economies have delivered strong growth, paid high dividends, and are free from the structural issues that limit its translation to EPS growth. Healthy demographics and “friendshoring” trends of moving supply chains outside of China are positive factors.
• Focusing predominantly on company fundamentals is critical, but the macro picture is still important, especially for scenario analysis. Exceptionally positive or negative macro outcomes can help to infer tail scenarios for certain asset classes, which may be more helpful to allocators than using macro to understand the central scenario.

What we are watching

• China industrial policy to boost growth and economic reforms including measures to directly support the market by tightening company fundraising rules to limit share issuance.
• With tech companies that invest in AI exhibiting explosive growth, market expectations continue to be high. Should capex in AI fail to yield the purported benefits and earnings disappoint, this could bring the US market back down to earth in line with its true economy.
• Impact of US monetary and legislative policy on EM and China, as higher for longer rates and a strong dollar have been a headwind for EM. The upcoming US election cycle and sentiment on continuing/expanding tariffs and trade restrictions.