Emerging Markets: Still An Important Asset Class?

Recently I meet a DCIO wholesaler at a conference who was promoting his firm’s newly developed target-date funds. I asked about their emerging market (EM) allocation and he said that their funds had no exposure to EM. He went on to explain that clients he had talked with “wanted nothing to do with the risk in those countries.” 

As it relates to the recent downward pressure on EM returns, it certainly seems that EM has entered a perfect storm of geopolitical and economical events. Plummeting oil prices (indicative of slower EM growth and hammering oil-producing EM countries), the potential for a 2015 Fed tightening and the continual strengthening of the greenback have mostly erased EM returns from earlier this year. 

Where it stands now is that, while EM has returned approximately 8% over the past 10 years, this asset class has been nearly flat for the last five years. Many EM investors are beginning to bail out of this asset class, and quite a few DC plan sponsors are not interested in adding EM exposure.  

A scan of investment literature found that, as one would expect, the views of EM as an asset class are all over the map.  

The Economist, representing the pessimists, has been generally negative about EM for many of the reasons discussed in an October article, “The Bear Case for EM.” In the article, the magazine takes the position that “blind faith” in EM due to “faster-growing, younger populations, lower costs and fewer debts, etc., now looks untenable.”

Taking what seems to be a longer view than The Economist, a recent article by Morningstar, “Don't Make Emerging Markets Your Investing Blind Spot,” recognizes that EM has significantly underperformed the developed markets (DM) over the last five years. However, in spite of this recent lag in return:

In order to to capture the superior historical EM returns relative to the DM, “emerging-markets stocks travel a much bumpier road than U.S. large-cap equities,” notes the article. How volatile? About 40% greater than the U.S. large-cap market based on 1-, 3-, 5- and 10-year standard deviation comparisons. 

It seems that the two requirements of investing in EM are: (1) to expect high short-term volatility; and (2) and to invest in this asset class (if one is to be prudent) only if one has an long–term investment horizon. I would speculate a bit and say that “long-term” would mean at least 10 to 20 years, with a bias toward the 10-year time frame, when EM valuations are trading at a significant valuation discount both on an absolute and a relative basis. 

Currently EM is trading at approximately a 40% discount to the S&P U.S. market, which would seem to build the case for a breakout to occur sooner rather than later. What the catalyst for that will be is anyone’s guess. A substantial weakening of the dollar, for one, would most certainly push EM prices up.

Going out beyond the 15-year mark, it’s hard to imagine that EM will not reverse its five-year underperformance trend relative to DM. As discussed in a recent upbeat Forbes article, “Transformational Tidal Wave Now Taking Shape In Emerging Markets Will Economically Change Our World”: 

Though we all swear that we are committed to long-term investing, the fact is that plan advisors and their plan sponsor clients find themselves being buffeted constantly by the seemingly endless bad news coming out of the emerging markets and the angst this news creates. When Putin says, “Do not mess with Russia … we are nuclear” and appears to be playing a game of chicken with the West, viscerally we feel as if we are sliding to World War III. And that is just one example of today’s scary scenarios. There are many more — lately, more than usual. Or is there just more in-your-face, up-close reporting of everything bad across the planet? Be that as it may, today’s events make it hard to stay the course, or even to convince plan sponsors to take a long-term perspective on EM investing.

At the core of a long-term optimistic view of EM is the belief that globalization, which can be messy to watch, is a real economic phenomenon and will likely continue unabated. As Jerome Booth stated in his recent book, Emerging Markets in an Upside Down World, “the term [globalization] is laced with emotive content, often negative, and while it creates jobs and wealth, globalization is, for many, associated with job losses and erosion of local values.”

Finally, there is all this talk about the impact of the U.S. economy on EM, as if it were a one-way street. EM suffering while DM thrives is simply not sustainable long-term. Consider a recent article, “Emerging Markets will Punish the US One Day,” in which Booth, an EM specialist and former head of research of the Ashmore Group, says this about the now famous “taper tantrum” that seems to be one fear that has kept EM asset prices down: "The [capital] flow from emerging market central banks today still completely outweighs the flow the other way. All of this talk about tapering affecting emerging markets is complete hogwash. It is absolutely minute compared to the flow the other way."

“Flow the other way” refers to the decision by EM countries to use U.S. dollars as their primary reserve currency. If this pattern were to start to reverse in a major way, the U.S. economy would find itself in a world of hurt. China (for the rest of EM to follow) would have to lead that move, but they are hesitant to do so given the way in which China’s fortunes are tied to the West, which in turn has its fortunes tied to the East.  The economies of DM and EM are inextricably bound together in a cross-dependence that no one can deny. This would indicate that fears which are rooted in what feels like an existential threat to the world economy are fears that rightly apply across all markets — developed and developing alike.