T. Rowe Price T. Rowe Price Trusty Logo

Price Perspective - In Depth

Asset Allocation:

The Changing Face of Emerging Markets

Timothy C. Murray, Capital Markets Analyst

Executive Summary

  • Emerging markets have evolved, and investors now need to look at them through a different lens.
  • Infrastructure-driven sectors, such as energy, materials, and industrials, have become much less important drivers of performance, while consumer-oriented sectors, most notably information technology, have dramatically increased in importance. This evolution appears likely to continue, as many countries, led by China, transition toward more consumer-driven economies.
  • For tactical asset allocation purposes, the outlook for commodity prices is still quite important to the relative performance of emerging markets equities, but it is now part of a much broader mosaic of factors.
  • Partially due to the ongoing trend toward more domestically driven economies, emerging market fundamentals are becoming more impacted by country-specific factors, making broad generalizations about the asset class more and more difficult. This makes evaluation more complex for tactical asset allocation purposes, but it also means that the alpha potential for active management is higher.

Emerging markets (EMs) are a different animal to what they were 10 years, or even five years ago. The term "emerging markets” is now more a matter of benchmark classification as opposed to some common fundamental factor. While perhaps sounding like a subtle distinction, the importance is both high and far-reaching for investors, from both a bottom-up stock-picking perspective, as well as from a tactical asset allocation perspective.

TAILWINDS FADE

Emerging economies, led by China, are the most important engine of incremental global economic growth. The dynamics of their economies, their growing share of world trade, and their increasing importance in global equity markets are trends of fundamental and long-term significance. According to projections by the International Monetary Fund (IMF) released in October 2017, emerging and developing economies will be responsible for 58% of all GDP growth over the next five years, with China alone responsible for 27%. By comparison, the United States is expected to be responsible for 17%.

Add to that the longer-term social aspects like urbanization and dramatically more attractive demographics than developed markets and it is easy to see why, conceptually, emerging markets equities seem as attractive an asset class as ever. Unfortunately, this attractive growth profile has not always translated into superior performance results—and in recent years, we have seen some important shifts in the dynamics of when and why emerging markets have outperformed (and underperformed) other regions.

Opening Quote In recent years, we have seen some important shifts in the dynamics of when and why emerging markets have outperformed (and underperformed) other regions. Closing Quote

In the late 1990s and early 2000s, EM equities delivered outsized returns relative to developed markets (Figure 1). During this period, many EM economies were boosted by China’s double-digit growth pace and massive investment in resources, leading to what was termed a “commodity supercycle.” This resulted in a virtuous cycle that benefited EM countries broadly—and several large countries in particular, such as Brazil, South Africa, and Russia, where natural resources are plentiful. It also meant that performance was heavily influenced by the direction of commodity prices.

However, as China began its transition to a more consumer-led economy, that powerful tailwind of rising commodity prices dissipated, and with it came a period of underperformance by EM equities (Figure 1). This caused much angst among investors as they tried to assimilate what had happened to the EM thesis. Were the unique qualities of emerging markets (i.e., superior economic growth and demographic advantages) enough to outweigh the cyclical exposure these markets held? Or had the experience of the 2000s proven they were simply an alternative way to increase exposure to commodity prices and other cyclically driven elements of the global economy? Recent evidence points to the former rather than the latter.  

FIGURE 1: EM Equity Performance Impacted by Shifting Dynamics 

Annualized Total Return in USD

Dec. 31, 2000–

Dec. 31, 2010

Dec. 31, 2010–

Dec. 31, 2017

MSCI Emerging Markets 16.21% -1.47%
MSCI World 2.81 5.20

Past performance cannot guarantee future results.
Sources: MSCI and FactSet. 

CHANGING DRIVERS

A look back over the last three years reveals that the relationship between commodity prices and EM equities has weakened significantly. EM equities had moved almost in lock step with energy prices from 2005 to mid-2014, but from 2014, they have moved much more independently (Figure 2A). This raises two questions: (1) Why did this relationship weaken and (2) Should we expect this to continue? 

FIGURE 2A: EM Equity Performance No Longer Riding Alongside the Commodity Cycle
EM Equities vs. Energy Prices, Cumulative Performance to December 2017

Past performance cannot guarantee future results.
Sources: MSCI and FactSet. 

FIGURE 2B: MSCI EM Correlation to CRB Spot Commodity Price Index
Five-Year Rolling, in USD, as of September 30, 2017 

Sources: MSCI and Credit Suisse research. 

A key factor in the change has been the sector composition of the MSCI Emerging Markets Index, where there has been a marked shift away from commodity and manufacturing areas into consumer-driven ones. Most notable is the growth of the information technology sector, while energy and materials sector weights have fallen dramatically.

Since 2012, the IT sector’s size withinthe MSCI Emerging Markets Indexhas doubled to almost 28% of theindex (Figure 3). That’s bigger than thetechnology weighting in the S&P 500 index at around 24%.1 Importantly, much of the change has been drivenby digital companies (i.e., “new tech”).

At the same time, the constituent weighting of the energy sector has almost halved, while the materials weighting has fallen to single-digit levels within theindex. Elsewhere, index sector weights have evolved less dramatically, but in a similarly thematic fashion. Those sectors in infrastructure-driven areas of the economy—industrials, utilities, and telecommunications—have trendedlower. Meanwhile, the sectors drivenby domestic consumption—consumer discretionary, health care, and financials—have trended higher.

FIGURE 3: Technology—The New Driving Force Within Emerging Markets
MSCI Emerging Markets Index—Sector Composition, as of December 31, 2012, and December 31, 2017 

Sources: MSCI and FactSet. 

OPPOSING DRIVERS, MIXED RESULTS

In addition to falling representation within the index, the performance of commodity areas has also been poor during the current cycle (Figure 4). As we have witnessed the slowdown in the demand for resources, we have seen sectors exposed to this trend underperform the wider market. Meanwhile, consumption areas have provided relatively strong performance, led by the technology sector. This dynamic has exacerbated the ongoing decrease in correlation between commodity prices and EM equities, as not only have energy and materials become smaller constituents, but returns for the sectors have been negative, while the majority of the benchmark has performed positively, particularly the technology sector.

FIGURE 4: Change of Fortunes as the Commodity Supercycle Fades 

Past performance cannot guarantee future results.
Sources: FactSet, MSCI, and data analysis by T. Rowe Price. 

EVOLUTION AND DURABLE CHANGE, WITH CHINA AT THE HEART

These trends in benchmark composition are unlikely to reverse anytime soon given the ongoing wealth creation and the organic rise in demand within local economies over time. Economists have long predicted that rising emerging markets incomes would propel a shift from export-led to consumption-led growth, and this shift is well underway across most areas of the advancing world. The rising middle class consumption story (Figure 5) shows few signs of stalling, with China alone having lifted more than 600 million people out of poverty over the past three decades.

China’s industrialization phase is clearly and intentionally fading, and as the economy has shifted away from an infrastructure and fixed asset investment led growth model, the consumption and the services sectors have generally picked up the slack. When looking at the data, we see clear evidence of this change, with services as a percentage of GDP growing (Figure 6).

FIGURE 5: Wealth Creation and Urbanization a Powerful Tool
Superior growth in middle class households 2015–2020 estimate. As of March 2016 

Sources: Euromonitor International and CLSA. 

FIGURE 6: China: An Evolving Story
China: Services Share of the Economy, 1992 to 3Q 2016 

Sources: Haver Analytics, IMF, and data analysis by T. Rowe Price. 

At the same time, more subdued economic growth in the developed world continues to erode the secular export theme within the whole of the emerging world. This leads us to suspect that EM fundamentals have evolved, and will continue to evolve, in a more self-reliant direction over time. China’s economy will not be the only one migrating toward a more consumption-oriented model.

An examination of the trade balance data shows that, indeed, many EM countries are seeing their trade balances narrow. Of the 10 largest emerging economies (based on GDP), the balance of trade for goods has narrowed over the last decade (Figure 7), except for Mexico. Net importers are generally importing less, while net exporters are also generally exporting less. 

FIGURE 7: Trade Balances Narrowing
As of December 31, 2016 

Source: FactSet.
*Data for India are unavailable prior to 2012, so 2012 number is shown. 

RISING DISPERSION

Partially due to this ongoing trend toward more domestically driven economies, emerging markets fundamentals are becoming more dispersed, making broad generalizations about the asset class more and more tenuous. You only need to look at performance on a country-by country basis to see that they cannot be viewed under one singular homogenous banner any more (Figure 8).

This is not a surprise to us given the ongoing economic and financial maturation within these countries. Few investors would group Japan, the UK, France, the U.S., and Australia together under a single banner, but since the emergence of emerging markets as an asset class 20 years ago, the fundamentals of India and Brazil have nonetheless been commonly associated with the fundamentals of the Philippines or Turkey, for example. However, the point of maximum fundamental correlation (remember the days of the BRICs ascending as one) was reached some time ago and has likely passed, leaving a more complex, and often confusing, situation in its wake.

A current view of sector weights further reveals the broad dichotomy of exposures by both country and region. Among the 10 largest countries by weight in the MSCI EM benchmark, information technology exposure ranges from over 60% (Taiwan) to 0%(South Africa, Russia, Mexico, Malaysia, and Indonesia). Meanwhile, energy weights range from 48% (Russia) to 0% (Mexico)(Figure 9). This dichotomy is also present on a regional basis, with information technology being the largest weight in Asia but barely represented in EMEA and Latin America (Figure 9). 

FIGURE 8: Emerging Markets Return Dispersion
March 2009 to December 2017 

Past performance cannot guarantee future results.
Sources: MSCI and FactSet. 

FIGURE 9: Sectors by Country and Region
Sector Weights by MSCI Country, as of December 31, 2017 

Sources: MSCI and FactSet. 

Dispersion is also rising on a more granular level than just on a regional or country basis. An examination of rolling 90-day intra-stock correlation of the MSCI EM index shows that stock correlation has been gradually falling, after peaking in November 2008 (Figure 10). This means emerging markets stock movements have been gradually becoming more independent for almost nine years, insinuating that getting choices right at the stock level is becoming even more important.

IT'S COMPLICATED

From an asset allocation perspective, the rise in dispersion means that we need to adjust our assumptions about what environments will be most beneficial, while also recognizing that the experience of active investors in EMs may be markedly different for passive investors.

Falling oil prices may be a catalyst for poor performance within Brazil or Russia, but it may mean that consumers in China and India have more disposable income to spend on food, travel, or entertainment—areas that are now more heavily represented within EMs. Meanwhile, numerous country-specific variables, such as the actions of central bankers and politicians, cultural trends, demographics, and even weather within each country, can have considerably more impact on each individual domestic economy.

One implication of this increasing dispersion within the asset class is we should expect EM equities to have a more muted reaction to specific macro forces going forward and, therefore, moderate our conviction regarding tactical allocations to EMs based on specific macro factors. Another is that we should expect falling correlation among equities within the EM universe and, therefore, should expect underlying stock selection to have a greater effect on portfolio performance.

For asset allocators, this ongoing change in emerging markets represents both a challenge and an opportunity. The playbook for allocating to emerging markets equities used to be more cyclically driven. In a nutshell, it went something like: Do you think global growth will be healthy? Do you think commodity prices will be strong? Do you think emerging markets currencies will be strong? If the answer to all these questions was yes, then EM equities were very likely to outperform other regions. Now one has to concede that it is much more complicated. Macro factors like global growth, commodity prices, and currency markets are still quite important, but they are now part of a much broader mosaic of factors.

The opportunity lies in the recognition of two important realities: (1) Emerging markets may continue to offer stronger economic growth trajectories than developed markets and (2) Emerging markets now include a much greater representation of country-specific influences.

Point one argues for the need to have exposure to EMs in portfolios with long time horizons, while point two argues for the need to gain this exposure through an active manager that is well equipped to identify the best opportunities within emerging markets.

Price Perspective

Asset Allocation: The Changing Face of Emerging Markets

Asset Allocation: The Changing Face of Emerging Markets
Read More...

 

1 Information technology weighting in the S&P 500 Index was 23.8% as of December 31, 2017.

 

201802-433910  

 

Important Information

This material is being furnished for general informational purposes only. The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, and prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. T. Rowe Price group of companies including T. Rowe Price Associates, Inc. and/or its affiliates receive revenue from T. Rowe Price investment products and services. Past performance is not a reliable indicator of future performance. The value of an investment and any income from it can go down as well as up. Investors may get back less than the amount invested.

The material does not constitute a distribution, an offer, an invitation, a personal or general recommendation or solicitation to sell or buy any securities in any jurisdiction or to conduct any particular investment activity. The material has not been reviewed by any regulatory authority in any jurisdiction.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass. The views contained herein are as of the date written and are subject to change without notice; these views may differ from those of other T. Rowe Price group companies and/or associates. Under no circumstances should the material, in whole or in part, be copied or redistributed without consent from T. Rowe Price.

The material is not intended for use by persons in jurisdictions which prohibit or restrict the distribution of the material and in certain countries the material is provided upon specific request.

It is not intended for distribution to retail investors in any jurisdiction.

Source for MSCI data—MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

FactSet—Copyright © 2018 FactSet Research Systems Inc. All rights reserved.

Australia—Issued in Australia by T. Rowe Price International Ltd. (ABN 84 104 852 191), Level 50, Governor Phillip Tower, 1 Farrer Place, Suite 50B, Sydney, NSW 2000, Australia. T. Rowe Price International Ltd. is exempt from the requirement to hold an Australian financial services licence in respect of the financial services it provides in Australia. T. Rowe Price International Ltd. is authorised and regulated by the UK Financial Conduct Authority under UK laws, which differ from Australian laws. For Wholesale Clients only.

Canada—Issued in Canada by T. Rowe Price (Canada), Inc. T. Rowe Price (Canada), Inc.’s investment management services are only available to Accredited Investors as defined under National Instrument 45-106. T. Rowe Price (Canada), Inc. enters into written delegation agreements with affiliates to provide investment management services.

DIFC—Issued in the Dubai International Financial Centre by T. Rowe Price International Ltd. This material is communicated on behalf of T. Rowe Price International Ltd. by its representative office which is regulated by the Dubai Financial Services Authority. For Professional Clients only.

EEA—Issued in the European Economic Area by T. Rowe Price International Ltd, 60 Queen Victoria Street, London EC4N 4TZ which is authorised and regulated by the UK Financial Conduct Authority. For Professional Clients only.

Hong Kong—Issued in Hong Kong by T. Rowe Price Hong Kong Limited, 21/F, Jardine House, 1 Connaught Place, Central, Hong Kong. T. Rowe Price Hong Kong Limited is licensed and regulated by the Securities & Futures Commission. For Professional Investors only.

Singapore—Issued in Singapore by T. Rowe Price Singapore Private Ltd., No. 501 Orchard Rd, #10-02 Wheelock Place, Singapore 238880. T. Rowe Price Singapore Private Ltd. is licensed and regulated by the Monetary Authority of Singapore. For Institutional and Accredited Investors only.

Switzerland—Issued in Switzerland by T. Rowe Price (Switzerland) GmbH, Talstrasse 65, 6th Floor, 8001 Zurich, Switzerland. For Qualified Investors only.

USA—Issued in the USA by T. Rowe Price Associates, Inc., 100 East Pratt Street, Baltimore, MD, 21202, which is regulated by the U.S. Securities and Exchange Commission. For Institutional Investors only.

T. ROWE PRICE, INVEST WITH CONFIDENCE and the Bighorn Sheep design are, collectively and/or apart, trademarks or registered trademarks of T. Rowe Price Group, Inc. All rights reserved.

201802-433910 

Dismiss
Tap to dismiss

Download

Latest Date Range
Audience for the document: Share Class: Language of the document:
Download Cancel

Download

Share Class: Language of the document:
Download Cancel
Sign in to manage subscriptions for products, insights and email updates.
Continue with sign in?
To complete sign in and be redirected to your registered country, please select continue. Select cancel to remain on the current site.
Continue Cancel
Once registered, you'll be able to start subscribing.

By clicking the Continue button, I acknowledge that I have read and accepted the Privacy Notice

Continue Back

Change Details

If you need to change your email address please contact us.
Subscriptions
OK
You are ready to start subscribing.
Get started by going to our products or insights section to follow what you're interested in.

Products Insights

GIPS® Information

T. Rowe Price ("TRP") claims compliance with the Global Investment Performance Standards (GIPS®). TRP has been independently verified for the twenty one- year period ended June 30, 2017 by KPMG LLP. The verification report is available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm's policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation.

TRP is a U.S. investment management firm with various investment advisers registered with the U.S. Securities and Exchange Commission, the U.K. Financial Conduct Authority, and other regulatory bodies in various countries and holds itself out as such to potential clients for GIPS purposes. TRP further defines itself under GIPS as a discretionary investment manager providing services primarily to institutional clients with regard to various mandates, which include U.S, international, and global strategies but excluding the services of the Private Asset Management group.

A complete list and description of all of the Firm's composites and/or a presentation that adheres to the GIPS® standards are available upon request. Additional information regarding the firm's policies and procedures for calculating and reporting performance results is available upon request

Other Literature

You have successfully subscribed.

Notify me by email when
regular data and commentary is available
exceptional commentary is available
new articles become available

Thank you for your continued interest