In a recent article from Yahoo Finance, “Why Emerging Markets Have More Room to Run”, the author shows a simple chart that clearly demonstrates the volatility of the emerging markets compared to the U.S. stock market.
The table demonstrates that, relative to the S&P 500, emerging markets historically have experienced wide swings in return. However, if an investor were to have had the stomach to stick it out between 1998 and 2013, they would have been rewarded with over 500% in additional total return. Annualized returns between 1988 and 2013 for the MSCI EM Index was 11.94% with a total new return of 1,776% compared with the S&P 500 Index during the same time period, which had a 10.50% annualized return and 1,242% total return.
One of the reasons that emerging markets are so volatile has to do with the limited capacity of their capital markets. It does not take much of a change in market sentiment to move the return needle — up or down — in the emerging market countries. As the author of the Yahoo Finance article points out:
- the entire Brazilian stock market is roughly the size as Google’s market cap;
- India’s equity market is worth the same as Nestle;
- Starbucks is worth as much as the entire stock market in Turkey; and
- Apple currently carries roughly $165 billion in cash — the equivalent to the size of the stock markets in Egypt, Columbia, Morocco, Chile and Poland combined
These rather dramatic relative differences in market capitalization will change considerably over the next 17 years, says a recent study by Credit Suisse, “The Emerging Markets: The Road to 2030”, According to this study, “emerging markets have a 39% share of global output (or 51% on a purchasing power parity basis) and yet account for only 22% of global equity market capitalization and a 14% share of both corporate and sovereign bond market value, respective.” The report says this will change and projects that, “by 2030, the emerging market share of global equities will increase to 39%, for corporate bonds to 36% and for sovereign bonds to 27%.” This growth in market capitalization — on an absolute basis and on a relative basis to the developed markets — represents the ongoing maturation of the emerging capital markets, which is introducing new investment vehicles at an increasingly faster pace.
Emerging market bulls are beginning to pound the drum about developing markets. In a recent article entitled, “Time to Invest in Emerging-Markets Stock Funds? Some Analysts Think It Is. But if You Do, Hold On to Your Hat”, The Wall Street Journal reported that “emerging-markets shares remain cheap compared with those of stocks in the U.S. and other developed markets, and growth forecasts are higher for emerging economies.” Given the lack of return opportunity in the bond markets and the growing view that developed countries equities have “stretched valuations”, it would be of no surprise to see a major rotation into the emerging markets sector.
Since February of this year, emerging markets have already outperformed the S&P 500 (15.7% vs. 9.4% as of July 30) — in spite of a rash of geopolitical events (Ukraine, Gaza, Syria and Iraq) as well as the uncertainties surrounding China’s market. If a positive sentiment should take hold and cause a significant sector rotation, one might conclude that developing markets could go through the roof — driven by nothing else other than demand. The developed markets have already experienced significant “margin expansion” (price increases not driven by an increase in earnings) in their respective equity markets. Consider the fact that the frontier markets (the 24 pre-emerging countries in the MSCI Frontier Market Index) have already experienced a 28% return during the last 12 months and have outperformed both the S&P 500 and the emerging markets with an YTD return of 18%. Finally, recent high equity returns in the developed markets have created an appetite for risky assets as investors seek to keep the momentum going.
Conclusion
In the end, it is not about chasing returns. Rather, it is about constructing an asset allocation portfolio that dovetails with one’s individual risk profile. As nearly all advisors agree, emerging market securities should be a (relatively small) component of an individual’s portfolio with the goal being to achieve a higher return while at the same time reducing a portfolio’s overall volatility. The challenge is that emerging markets have historically been highly volatile, which many attribute both to the uncertainties of these less developed economies as well as their limited capacity to absorb major shifts of investment capital.
As the Credit Suisse report projects, these maturing emerging markets will progressively represent a greater share of the world’s investment opportunities. To note again, the emerging markets represent 22% of the world’s equity market-cap today with a projection of 39% by 2030. As this growth in market capitalization occurs, we should see the volatility of the emerging markets decrease (relative to developed markets) as well as progressively represent a growing share of the typical asset allocation portfolio.
