Markets & Economy
Emerging Markets: Reward or Risk?October 22, 2019
- Emerging markets (EMs) have evolved, and investors need to look at them through a different lens. It’s important to stay alert to the changes happening in this dynamic asset class.
- Dispersion is much higher compared with other asset classes, offering opportunity for active investors with enough resources.
- Trade disputes and slowing global growth are challenging, making the outlook more opaque in the short term. However, fundamentals remain strong, and opportunities can be found.
Investing in the emerging world over the last 10 years has provided positive returns in both equities and debt but far less than the same spectacular returns of the previous decade. Some are questioning if there are still rewards to be found within the developing world.
Strong evidence suggests there is, even though many investors remain structurally underweight the asset class, despite the importance of EMs to the world. Along with many secular drivers, EMs continue to demonstrate a range of growth characteristics that are not easily available in developed markets. This enables higher‑quality companies in certain sectors to generate sustainable earnings growth at a much higher rate than the global average. (Compounding returns can be a powerful driver of future returns.) Meanwhile, in the search for yield, EM debt offers much higher rates than developed markets, many of which now have negative yields. Valuations across the asset class also remain attractive, further supporting investment.
Do the Fundamentals Still Add Up?
Significant headwinds, such as the bursting of the commodity bubble, China’s slowdown, weak global exports, and the strong U.S. dollar, have clouded the environment over the last decade. We have also seen a narrowing of the economic growth premium versus developed markets while corporate earnings growth has been weaker due to a combination of cost pressures (including wage growth) and softening demand. The increasing threat to globalization—only heightened by the trade dispute between China and the United States—is also one of the big challenges EMs now face as global supply chains become more disrupted.
Nevertheless, led by China, EMs are one of the most important drivers of global economic growth. Add to that longer-term aspects like urbanization, productivity, and, for many EM countries, far more attractive demographics, and you get an opportunity set with many interesting and attractive investments.
Past Performance Is Not a Reliable Indicator of Future Performance
In the late 1990s and early 2000s, EMs delivered outsized returns relative to developed markets. Many EM economies were boosted by China’s double‑digit growth pace and massive investment in resources, leading to what was termed the “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. This has been especially apparent over the last five years as the relationship between commodity prices and EM equities weakened significantly. As seen in Fig. 1, EM equities moved almost in lockstep with energy prices from 2005 to mid‑2014 but have since moved with less correlation as the weight of those commodity sectors declined in the index.
EM equities less correlated with energy prices
Cumulative performance, January 2005 to August 2019
Past performance is not a reliable indicator of future performance.
Sources: FactSet (see Additional Disclosures) and MSCI (see Additional Disclosures).
By contrast, information technology, internet, and consumption sectors increased (Fig. 2) and have become more influential.
What we have to recognize is that EMs are a different animal from 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, it is an important one.
Consumer and technology sectors rise in importance to the detriment of commodity-related areas
MSCI Emerging Market Index Weightings
Sources: FactSet (see Additional Disclosures) and MSCI (see Additional Disclosures).
Evolution and Durable Change, With China at the Heart
Economists have long predicted that rising EM incomes would propel a shift from export‑led to consumption‑led growth, and this shift is well underway in many emerging markets. China is at the heart of this, with its industrialization phase clearly and intentionally fading, while consumption and services sectors have become far more important.
Other EM economies are similarly having to adapt to this lower‑growth world. Many are becoming more self‑reliant and increasing trade among themselves, reducing their dependence on developed markets, and the U.S. in particular. This is a marked shift and should further spur their own development.
With this ongoing trend toward more domestically driven economies, EM fundamentals are becoming more localized, making broad generalizations about the asset class even more tenuous. One only needs to look at performance on a country‑by‑country basis to see that they cannot be viewed under one homogenous banner anymore.
This dispersion also means that we need to adjust our assumptions about what environments could be most beneficial. Falling oil prices may be a catalyst for poor performance within Russia or the Middle East, 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.
This ongoing change represents both a challenge and an opportunity. The playbook for allocating to EM equities and bonds is no longer solely cyclically driven. In the past, we used to ask questions like: Do you think global growth will be healthy? Do you think commodity prices will be strong? Do you think EM currencies will be stable? If the answer to all these questions was yes, then EMs were very likely to outperform other regions. Now one must concede that it is much more complicated. Macro factors like global growth, commodity prices, and currency markets are still important, but they are now part of a much broader mosaic.
The opportunity lies in the recognition of two important realities: (1) EMs may continue to offer stronger economic growth trajectories than developed markets, and (2) EMs now reflect a wider range of country‑, sector‑, and stock‑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 exposure in a more active way to identify the best opportunities within EMs now.
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Financial data and analytics provider FactSet. Copyright 2019 FactSet. All Rights Reserved.
MSCI and its affiliates and third party sources and providers (collectively, “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. Historical MSCI data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. None of the MSCI data is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such.
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The views contained herein are those of the authors as of October 2019 and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.
This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.
Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.
Past performance is not a reliable indicator of future performance. All investments are subject to market risk, including the possible loss of principal. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. All charts and tables are shown for illustrative purposes only.
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