Skip to main content

You are here


Emerging Markets: Changing Dynamics

Principal Global Investors and The Principal Financial Group® released a report this week, Not All Emerging Markets are Created Equal. Principal commissioned the independent study, which was conducted by CREATE-Research and covered more than 700 pension plans, sovereign wealth funds, pension consultants, asset managers and fund distributors across 30 countries with combined assets under management of $29.7 trillion.

The extensive study, which covers a broad range of interesting topics, has as its central theme the fact that it is becoming increasingly difficult to put all emerging market countries in the same basket. There are countries that are “converging” with the developed markets (e.g., China); there are countries that are “pre-emerging” (e.g., frontier markets in Africa); and then there’s everything in between (e.g., Brazil). Its conclusion is that investors need to be more selective in both the countries they choose to invest in and the selection of individual securities in those countries. The message: be more active and less passive, more tactical and less strategic, and deploy custom portfolios verses commercial indices.

More Negativity Seen

What is also interesting is the amount of pessimism that has recently formed concerning emerging markets. From 2012 to 2014, the percentage of “believers” dropped from 38% to 20%, while “skeptics” increased from 18% to 28%, “cynics” increased from 15% to 19% and “deserters” increased from 6% to 12%. This seems like a great deal of negativity to have developed over just the last two years.

Opportunity and Risk

According to some observers, many investors argue that, as Seeking Alpha said, “emerging-market stock prices are cheap compared to the U.S. market. The iShares MSCI Emerging Markets Index ETF has a price-to-earnings ratio of 11, whereas the SPDR S&P 500 ETF's price-to-earnings ratio is 17…. based on these numbers, emerging markets are on sale: 35% off relative to the U.S. market.”

The Principal report, however, takes the position that “associated risks can no longer be priced in at today’s low market valuations: especially when the global economy itself is marred by extreme uncertainty.” The “uncertainties” of which the study speaks seem mostly rooted in the Fed’s exit strategy and the impact of continued worldwide deleveraging. In other words, how will the recent “great Keynesian experiment” — kicked off in response to the Great Recession — ultimately end?

Change in Investor Sentiment

If there were indeed a lot of investor angst over the government’s pumping of money into the economy, one would expect that investors would be more bearish about the U.S. economy. However, the study notes, this is not the case given that “nearly 65% of investors believe the U.S. government will make significant progress in rebooting its economy over the next three years.”

The study also found that the largest percentage of respondents (nearly half) believe the U.S. will offer the best returns over the next three years. This positive investor sentiment is rooted in “the belief that the economic recovery and rising stock markets are now anchored in improving economic fundamentals, not just sugar highs from the Fed.” Investors espousing this type of attitude appear to be assuming that the great Keynesian experiment is going to result in a soft landing — that the “kick the can down the road” strategy is working. This raises a question: Why the sudden change in sentiment about prospects in the emerging markets?

Three Key Drivers

The low returns (which were led by Russia and Brazil) in 2013, especially when compared to the high returns of the U.S. markets over the same period, is one likely culprit in the change in sentiment. Also, a factor that is not discussed in the report pertains to recent geopolitical events, including the war in Syria, military coups in Egypt and Thailand, the increased destabilization of Iraq, the “have not” riots in Brazil and the Russian land grab in the Ukraine. At least on a visceral level, recent low returns and regional instability makes the emerging markets appear both sickly and a bit scary.

There is also the argument that emerging markets are having a difficult time due to lower GDP growth and earnings forecasts — as reported this week in a Barron’s blog post, for example. As the post relates, UBS is reported to be taking the position that 30% of the poor performance in emerging market losses are related to lack of growth, with the balance due to deteriorating earnings. The latter is viewed by Barron’s as a result of “pursuing a strong top-line growth instead of heeding profitability.” What may be required, as stated in the Principal study, is that emerging economies need to create new sources of competitive advantage to maintain their high growth rates.


Referring to the emerging markets as a single asset class is becoming increasingly difficult to do. To achieve greater precision in the asset allocation process will require that undeveloped countries be evaluated in a manner that recognizes these differences. While emerging markets appear to be a bargain at current valuations, these countries may be losing their ability to create sufficient top-line growth as well as a sustained growth in earnings. With weakening revenue and earnings growth, it may be difficult to justify the added risks inherent in these markets.

In spite of relatively high valuations, the view that the U.S. market is the most promising place to invest may be indeed be on target. This may have to do with the U.S. being in the enviable position of being the center of advanced technologies, with a mature financial sector, strong immigration (both to fill jobs and expand the consumer base), an expanding energy sector and emerging technologies that could start bringing manufacturing jobs back to the U.S. (e.g., 3-D printing).

Being the lone superpower also helps when the need arises to apply soft or hard power. Whatever the reasons may be, most institutional investors believe that the U.S. is the best place to invest, at least for the next three years.