Emerging Markets Offer Emerging Opportunities by Neil MackerFor many U.S.-based individual investors, emerging markets represent the “Wild West” of investing, offering unmatched and almost limitless returns. In the view of others, the term “emerging markets” invokes the specters of extreme risk and political instability. Most investors tend to either lump emerging markets into one large bucket or simply examine the BRIC (Brazil, Russia, India and China) markets. Financial pundits have recommended emerging markets as an asset class for hedging due to historically low correlation with the U.S. stock market. Let’s discuss these commonly held beliefs and why we still believe in the importance of an emerging markets allocation in your portfolio.
Wild West?Until recently, many investors viewed emerging markets as a magical place that provided astronomical returns, driven by “China” and “commodities”. The idea that emerging markets can move upwards without large downward swings, though is hard to justify. Even before the events of 2008 the two largest, most diversified emerging markets (India and China) experienced wild swings in annual results as seen in Chart 1. Also, note that the S&P 500 outperformed the primary emerging market indices in only two of the nine years from 2000 to 2008. Both outperfomances occurred during recession years (2001 and 2008).
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Despite the large downward swings, the two primary emerging markets offer significantly higher average returns since January 2000. Table 1 shows what a hypothetical investment of $10,000 in each index at the beginning of 2000 would have been worth as of June 30, 2009. Returns for both of the emerging market indices are more than three times that of the S&P 500.
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Even when we cherry pick the best four-year continuous sample for the S&P, the U.S. index provided lower returns as shown in Table 2.
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Frontier Markets vs. Maturing Developing MarketsThe large swing in returns likely causes some investors to adopt the pessimistic view of emerging markets as pools of extreme risk and political instability. Part of this belief may lie in the inability of investors to segregate emerging markets. A simple method of separating emerging markets is to define a non-developed market as either a frontier market or maturing developing market.
Frontier markets include countries such as Bahrain, Bangladesh, Botswana, Bulgaria, Cambodia, Colombia, Cote D’Ivoire, Croatia, Ecuador, Estonia, Georgia, Ghana, Jordan, Kazakhstan, Kenya, Kuwait, Lebanon, Lithuania, Nigeria, Oman, Pakistan, Panama, Qatar, Romania, Slovenia, Sri Lanka, Tunisia, Ukraine, United Arab Emirates, Vietnam, and Zimbabwe. The equity exchanges in frontier markets feature undercapitalization and weaker regulatory frameworks along with lower levels of foreign ownership, borrowing, liquidity, and transparency than maturing developing markets. Most frontier markets also suffer from political instability, tenuous financial policies, and lesser- developed/diversified economies. Historically these countries have conformed to the pessimistic view of emerging markets and as such, most investors outside the most aggressive should stay clear of frontier markets.
Maturing developing markets include the big four BRIC markets along with familiar names such as Israel, Mexico, South Africa, South Korea, Taiwan, and Turkey. Many investors have focused on the BRIC countries as those markets have benefited from investor in-flows and high GDP growth sparked by export growth (China and India) and commodity price increase (Russia and Brazil). However, the other markets also offer relative political stability, more diversified economies, larger domestic markets, lower levels of official/government corruption, and more robust ties to the developed countries.
Diversification, Not a HedgeTies to developed countries have in part led to the demise of the “de-coupling” theory, which stated that emerging markets had effectively moved far away from developed countries and would not be affected by a meltdown in the developed world. Some financial pundits advised that emerging market investments would act as a “hedge” against investments in developed markets. Even before the events of last year, the theory was already beginning to lose adherents as correlations between emerging market ETFs and the S&P 500 ETF (SPY) rose and as investment dollars began to flow in larger amounts into emerging market funds. After the global meltdown in 2008, where correlations among all asset classes increased, the idea of “de-coupling” faded as did the concept of hedging using asset classes.
The FutureSo with no appreciable value as a hedge and increased risk, why allocate funds into emerging markets? While emerging market investments do not provide a strict hedge, the investments do offer diversification benefits as the correlations remain below one (at correlation of one, two assets classes would move in lockstep). Also, emerging markets provide access to different risk premia in the same way that an allocation to U.S. small and mid-cap stocks does despite the two sectors having a much higher correlation to each other than US equity and emerging markets. Another factor in favor of emerging markets is higher GDP growth over the near future. The only two major economies, developing or otherwise, that are projected to have GDP growth in 2009 are China and India as seen in Chart 2. Projections for 2010 also predict that China and India will also have the largest GDP growth of 9% and 7% respectively, versus 6% for emerging markets and 1% for developed economies.
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Another reason to allocate to emerging markets is as the U.S. and most governments in the world inject funds into domestic economies, the level of public debt is projected to increase dramatically. As seen in Chart 3, the U.S. was in relatively decent standing with public debt at 40% of GDP at the end of 2008, but was well behind three of four BRIC countries. Current Congressional Budget Office projections estimate that the U.S. public debt to GDP will reach 51% at the end of 2009 and will peak at 54% in 2011. These projections reflect the belief that the government will move back towards a more balanced budget versus the $1.5 trillion deficit projected for 2009. Some commentators such as Bill Gross of PIMCO, suggest that the U.S. government may have to continue running trillion dollar deficits over the next several years and that the new “normal” GDP growth rate will be 1% to 2% versus the 3%+ of the past.
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As the U.S. and other developed countries increase overall debt levels, their corresponding stock markets will experience increased risk levels with lower expected returns. As a result, emerging markets may provide greater risk/return rewards.
Given these factors, we continue to believe that allocation to emerging markets is appropriate for many clients. The amount allocated to emerging markets will vary by portfolio given individual risk tolerances/time horizons and will change over time as we continue to monitor the economic factors.
