Emerging Markets Offer Dubious Investment Appeal


U.S. stock markets are tumbling but shares from developing economies have fallen just as fast. Since the start of the year, the S&P 500 Index of big U.S. companies is down about 17%; the MSCI Emerging Markets Index has dropped 18%. This basket of stocks, containing shares in companies from Brazil to the United Arab Emirates, now looks relatively good value. Investors who bought these equities when they were cheap at the turn of the century enjoyed excellent returns. Unfortunately, China’s increasing weight suggests that happy experience won’t be repeated.

In the early 1980s the Dutch economist Antoine van Agtmael wanted to launch a “Third World Investment Fund” but was told the name wasn’t catchy enough. So he came up with the more upbeat “emerging markets”. In 1985, the first index tracking these stocks was launched. A couple of years later, MSCI created its own benchmark. Fund managers promoted the new asset class with the promise that higher rates of economic growth across the developing world would be accompanied by superior equity returns. In 2001, Goldman Sachs forecast that the economies of Brazil, Russia, India and China (the BRICs) would overtake the developed world within decades. Van Agtmael hailed the “Emerging Markets Century”.

The problem with this idea is that there is no correlation between economic growth and equity returns. In theory, in a world with free capital flows, shareholder returns from different stock markets should converge. Historic data from various countries since 1900 confirms that investors have not done better by picking markets with the highest economic growth.

In fact, the opposite has been the case. In the short run, countries with the fastest GDP growth have tended to deliver the lowest returns, while economic laggards have done best. Look at China’s recent experience. In the last three decades China’s GDP has grown more than 30-fold in U.S. dollars. Yet over this period the total return on Chinese equities has averaged just over 2% a year, again in dollar terms.

Van Agtmael was on firmer ground when he argued that investing in emerging markets would diversify portfolios, thereby lowering risk and enhancing returns. According to MSCI, the trailing one-year correlation between emerging and developed markets is around 0.4, a little below its long-term average. Markets that move in perfect unison would have a correlation of 1. Adding emerging stocks to investment portfolios has paid off. Since the turn of the century, the MSCI Emerging Markets Index has marginally outperformed the MSCI World benchmark of developed markets.

The trouble is that emerging markets are no longer as diverse as they used to be. China, which wasn’t part of van Agtmael’s original index, now accounts for around 30% of the MSCI benchmark. Thus future investment returns from emerging markets now largely hinge upon what happens in the People’s Republic.

There are grounds for pessimism on this front. Investors only thrive in countries where the rule of law holds sway. Yet shareholder rights count for little in modern China. Last year, in the name of “common prosperity”, President Xi Jinping went after Chinese education companies, real estate firms and tech giants. The president’s taste for absolute control has been reflected in China’s zero-Covid policy, which has recently resulted in a new round of rolling lockdowns and economic disruption across the country.

To some extent these risks are reflected in current valuations for emerging market equities, which trade at a significant discount to Western stocks. But investment strategist John-Paul Smith, who started running an emerging markets fund in 2001, suggests that that the opportunities on offer today are not as compelling as two decades ago. At the time my former employer, the asset manager GMO, forecast that emerging market equities would deliver annual real returns of nearly 8% over the coming years. That prediction turned out to be remarkably accurate. GMO’s most recent forecast is for emerging markets to return just half that amount.

What made emerging market stocks such a good bet at the turn of the century, says Smith, is that the Asian financial crisis of the late 1990s propelled a number of macroeconomic and microeconomic reforms. Governments were forced to rein in public spending. Banking regulations improved and bankruptcy rules were more strictly enforced, driving the weakest firms to the wall. Emerging markets appeared to be embracing the Anglo-Saxon model of capitalism. Over the past decade, however, they have moved in the opposite direction. State capitalism, says Smith, is the kiss of death for investors. Creative destruction is not a policy option.

What should investors do? Smith believes the concept of emerging markets as a separate asset class is outdated. In his view, it was always a marketing device to draw investors into funds that charged higher fees. He suggests that emerging market investments should be folded into global equity portfolios. At the very least, they should be renamed “less developed markets” to alert investors to their generally weak governance and lack of liquidity.

Russia’s recent exit from the Western financial system shows that emerging market investors face the occasional prospect of a complete wipe-out. This was not a one-off. Russian shareholders lost everything in the revolution of 1917, as did Chinese shareholders when the Communists took power in 1949. Japan’s stock market fell 98% in real terms during World War Two. A study by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School shows that investors in emerging markets never recovered from these devastating losses.

At the time of the invasion of Ukraine, Russian equities accounted for around 2% of the emerging markets index. Such a loss can be easily absorbed. But China’s weighting in the benchmark is 15 times greater. Given rising political tension, foreign investors cannot completely ignore the risk that they will lose their shirts in China.

Some emerging market investors are therefore choosing to take China out of the picture. The Emerging Markets ex-China Index is a more balanced portfolio with less geopolitical risk but without any apparent sacrifice of prospective returns. In the investment world that’s called a no-brainer.

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