Is now the moment to get back into emerging markets (EM)? Six months ago, you might have laughed at the suggestion. Russia might have been written down to zero in your EM fund and Xi Jinping looked to be doubling down on a seemingly irrational Covid containment policy. Things look very different today as China opens up and the developed world flirts with a re-run of the 2008 credit crunch. Russia remains a pariah, but the hit has been taken.
The performance of EMs has been to say the least volatile. The MSCI EM index, expressed in dollars, is pretty much exactly where it was ten years ago. Along the way, it has been a rollercoaster ride. The index lost more than a quarter of its value in 2015. By February of 2021 it had nearly doubled from its pandemic low point but by last October’s Chinese Congress it had given back almost all of those gains. Over the following three months it added nearly 25pc. And breathe.
For a decade, EMs have played second fiddle to the in-vogue, technology-driven US market. While the developing world’s stock markets have gone sideways, with plenty of sleepless nights along the way, the US has soared. By its peak at the start of last year, the S&P 500 had trebled since 2013. As the US benchmark tumbled in the first nine months of last year, the EM index followed suit, only more so.
So, EM can be exhausting. We know that. But over longer periods are you compensated for the ups and downs? Potentially yes, to an extent, if you have the emotional grit to stick with it. If you had invested at the end of 2000, you would likely have enjoyed almost exactly the same return from the MSCI emerging markets index as from the S&P 500. And yes, I’m picking my time horizon to suit my argument, but you get the picture.
Perhaps unsurprisingly many investors have taken the view that similar returns with more volatility is not a great trade-off. Global portfolio managers might be expected to have about 12pc of their money invested in emerging markets on the basis of their weighting in the All-World index, but they actually have about 9pc. If you consider that China’s weighting in the global indices is artificially low because of the historically limited access to its shares for overseas investors, then the underweight is even more pronounced.
So, are investors right to be wary? Or does the last decade’s underperformance set us up, as it has from time to time in the past, for an extended period of outperformance. Is the last six months’ return to favour a flash in the pan on the back of China’s Covid U-turn, or the start of something more significant?
The first thing to understand is what you are getting when you invest in an EM fund. One that sticks to the weightings of the various countries captured by the EM indices, will likely have around three quarters of its money invested in just four countries: China is about a third of the MSCI emerging market index, Taiwan represents another 15pc, South Korea and India both contribute about 12pc each. Brazil is the largest of the rest at just 5pc.
So, not many countries but already you can see that it is quite hard to generalise about the kind of exposure you are buying into. There’s obviously a big consumption story but the five countries here are at very different stages of their development. Most of them are big commodity importers, one relies on exports. There may be a play on demand in the developed world, especially in the technology sectors.
The case for investing in EMs has three timescales. The long-term argument is one we are all familiar with. They account for: 70pc of the world’s population and half of its land mass; 40pc of its economic output; and 60pc of its growth. The difference between the growth rates in the emerging and developed worlds may have narrowed but it is still meaningful and sustainable. The low hanging fruit of moving large populations from rural subsistence to urban consumption may have been harvested but the transition from low to middle and higher incomes is ongoing with potential opportunities in sectors that target that growing middle class such as consumer finance, for example.
The second medium-term timescale reflects the transition from the post financial crisis era of US exceptionalism in which the expansion of America’s technology sector allowed Wall Street to flourish while the rest of the world struggled with sluggish growth. With profit margins at unsustainably high levels, sky-high debts and a weakening currency, the US looks to be running out of road versus an emerging world with more sustainable borrowings, healthier current accounts, further advanced in its inflation-fighting monetary cycle and with better demographics.
And then there’s the short-term case, which has two principal drivers: the re-opening of China and the yawning gap between stock market valuations in the US and in emerging markets. The recent rally in response to the improving backdrop in China has barely made a dent in the differential between emerging markets on around 12 times expected earnings (even accounting for India’s much higher rating) and the US on 18.
This, in my view, leaves just two questions. How to invest and how much?
