Tim Side | Research Analyst
Recent market events have created a significant amount of uncertainty in global markets. A year that began with concerns over tighter monetary policy amidst rampant inflation has now been exacerbated by the upending of world order with Russia invading Ukraine and Western countries implementing significant sanctions in response. This post seeks to address several of the questions that we have received from clients regarding Russia and the reasoning behind retaining an emerging market allocation in one’s portfolio. We do not know what will happen, but we do know that over time, staying the course with one’s deliberate investment plan has proven to provide the best chance for investors to achieve their goals, even when it seems like near-term certainty has become unhinged.
Emerging markets are no stranger to uncertainty or volatility. Certain regions in emerging markets have been hit hard recently by geopolitical events, most notably in Eastern Europe which has borne the brunt of the downside effects from the invasion. However, while Russian stocks have effectively dropped to zero and been removed from major indices, it is worth noting that the recent underperformance in broad emerging markets has been quite contained in the context of emerging markets’ longer history.
Since the inception of the MSCI Emerging Markets Index in 1987, the average rolling 12-month return has been 13.1% with a standard deviation of 27.6%. This means that 68% of the time, rolling 12-month emerging market returns have fallen between -14.5% to +40.7%. With a trailing 12-month return of -11.1% as of March 31st, 2022, we are well within expectations for the asset class historically.
One can see how this recent downdraft fairs relative to rolling 12-month periods since inception with the highlighted column in Figure 1 showing where today’s returns fall.
Is this time different?
China’s outsized presence in emerging market indices and the increasingly pervasive idea of markets becoming “uninvestable” are certainly topics that cannot be ignored, but these concerns are not new to emerging markets. By definition, these are emerging economies with a range of countries subject to varying degrees of unstable governments, poor shareholder protections, human rights violations, barriers to capital flows, etc. Despite these issues and periods of deep drawdowns, emerging markets have proven to be a diversifying source of returns and a good complement in investors’ portfolios.
In the words of Warren Buffet: “Be greedy when others are fearful, and fearful when others are greedy.” This approach necessitates a strong discipline since it often requires buying in the midst of uncertainty. The normal course of rebalancing allows investors to remove emotion and fear and take advantage of emerging markets trading at a significant discount to fair value, as seen in Figure 2.
A long-term mindset is needed in these markets given emerging markets are at various stages of maturation in their market, political, regulatory, legal, and economic systems. This is key to why markets demand a higher risk premium relative to developed markets. Sharp drawdowns often occur over short time-periods, but over the long-run, emerging markets have consistently been a strong source of returns. The long-term success can be seen in total returns since the MSCI Emerging Market Index’s inception in Figure 3.
These long-term return results combined with forward-looking estimates (Moneta’s Capital Market Assumptions are available upon request) make emerging markets one of the highest return/risk allocations in investors’ portfolios and a key component to achieving long-term investment objectives.
In addition to the return component, emerging markets also bring a high level of diversification to equity returns. Following recent market events, it is tempting to think about emerging markets as only Russia and China; while sizable, these two countries, respectively, made up approximately 3% and 32% of the index before Russia invaded Ukraine. The rest of the index is widely diversified across regions, countries, and sectors; this was clearly seen in February when Russia and other Eastern European countries sold off, but other areas such as South Africa and Brazil had positive performance, benefitting from their exposure to commodities. While shorter time periods can see correlations between all equity asset classes rise, emerging markets have proven to be a strong diversifier over long periods.
Following a decade-long run where US markets have significantly outperformed non-US markets, the diversification benefits are harder to see. But it is important to step back and look at longer time periods. A clear example can be seen in the first decade of the 2000s, where US equities were almost flat while emerging markets returned more than 150% (see Figure 4).
There is strong rationale for the higher return expectations in emerging markets beyond the risk-premium story. In the near-term, there is a robust case for the benefits of emerging markets’ commodities production (which typically perform well in inflationary environments), but longer-term there are also strong structural growth opportunities in emerging markets.
The growth opportunities are driven by large countries (from a population perspective) seeing rapid improvements in education and technology leading to a growing middle class, and importantly, one that shifts into more discretionary spending. Figure 5 comes from J.P. Morgan and Brookings Institution and highlights these growth expectations.
As a result, GDPs are expected to grow much faster in these emerging economies versus developed economies, which are saddled with demographic drags. We are already seeing an increase in US companies’ revenue coming from these regions, primarily from China.
The Importance of China in Emerging Markets Exposure
The emerging markets universe has undergone significant changes since the launch of MSCI’s Emerging Markets Index in December 1987. At that time, the index covered ten countries, making up less than 1% of the global equity market. Today, the index covers twenty-five countries and accounts for 8-10% of the global equity market.
In late 2001, Jim O’Neil, Head of Global Economic Research at Goldman Sachs, put forward a research paper that projected four emerging market economies would achieve higher real GDP growth than that of the G7. These four countries included Brazil, Russia, India, and China; hence the acronym “BRIC” was formed.
Fast forwarding to the end of 2020, we can see that from a dollar-GDP perspective, O’Neil was correct as BRIC countries saw an average annualized growth rate of 9% vs the G7 countries’ average annualized growth rate of 3%. Additionally, BRICs total percentage of global GDP increased from 8% in 2001 to 24% in 2020. The growth of BRICs has been primarily driven by China, which ended 2020 with a GDP of $15 trillion and captured more than 17% of global GDP (the US had a GDP of $21 trillion and made up almost 25% of global GDP).
While the role of BRICs appears to be diminishing as sanctions are likely to hinder Russian growth and Brazil continues to face political and economic challenges, China’s presence as a dominant global economic entity has been well established. The growth of China’s market has been reflected in global equity markets, but not nearly to the same degree as GDP contribution. On a global equity market basis, China is just over 3% of the MSCI All Country World Index (ACWI); significantly less than the US’s exposure of 61%.
In recent months, there has been a heightened concern regarding China and Taiwan and whether we will see a similar outcome to Russia and Ukraine. Given China’s large weight in the index, the question is frequently asked if one should divest from China given the global economic response to Russia’s actions in Ukraine?
It is far beyond anyone’s ability to predict what will happen with China and Taiwan, but it is important to guard against extrapolating the fat-tail (lower probability, higher risk) event of Russia invading Ukraine and assuming a worst-case scenario will occur with China and Taiwan. China and Russia are not the same and enacting the same sanctions on China would be far more difficult to implement than with Russia (in 2021, the US had a net-import balance of $355 billion from China vs $23 billion from Russia). This is not to say it cannot happen, but rather that it is a fat-tail event that can be mitigated rather than entirely avoided.
With a 32% weight in emerging markets, divesting from China by going into an ex-China strategy would be a massive macroeconomic country bet that are notoriously difficult (perhaps impossible) to correctly predict with any level of consistency. Given China’s generally strong performance over the last decade, the MSCI EM ex China Index has underperformed the MSCI EM; to be sure, in periods like 2021, the ex-China strategy outperformed by more than 12% due to China’s selloff following tighter industry regulations.
For better or worse, China’s size makes it impossible to ignore. To stay invested introduces the risk of a Russia/Ukraine type scenario, while divesting risks missing out on a prominent return component in one’s portfolio. In a well-diversified portfolio, we view the upside potential well worth the downside risk.
While emerging markets are seen as a single asset class, there is tremendous diversity within it. The spheres of influence appear to be rapidly shifting, but rapid change and reshaping of geopolitics are nothing new to the asset class. Argentina is vastly different from South Korea. Russia is vastly different from India. Given this diversity and the nature of emerging markets, one never has to look far to find a crisis, but over time, investors who have stayed the course have been rewarded with strong returns and diversification benefits.
© 2022 Moneta Group Investment Advisors, LLC. All rights reserved. These materials were prepared for informational purposes only based on materials deemed reliable, but the accuracy of which has not been verified; trademarks and copyrights of materials referenced herein are the property of their respective owners. Examples contained herein are for illustrative purposes only based on generic assumptions. Given the dynamic nature of the subject matter and the environment in which this communication was written, the information contained herein is subject to change. This is not an offer to sell or buy securities, nor does it represent any specific recommendation. You should consult with an appropriately credentialed professional before making any financial, investment, tax or legal decision. You cannot invest directly in an index. Past performance is not indicative of future returns. All investments are subject to a risk of loss. Diversification and strategic asset allocation do not assure profit or protect against loss in declining markets. These materials do not take into consideration your personal circumstances, financial or otherwise.
The Russell 1000® Index is an index of 1000 issues representative of the U.S. large capitalization securities market.
The Russell 2000® Index is an index of 2000 issues representative of the U.S. small capitalization securities market.
The MSCI EAFE Index is a free float-adjusted market capitalization index designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.
The MSCI Emerging Markets Index is a float-adjusted market capitalization index that consists of indices in 21 emerging economies.
Gross Domestic Product (GDP) at purchaser’s prices is the sum of gross value added by all resident producers in the economy plus any product taxes and minus any subsidies not included in the value of the products. It is calculated without making deductions for depreciation of fabricated assets or for depletion and degradation of natural resources. Data are in current U.S. dollars. Dollar figures for GDP are converted from domestic currencies using single year official exchange rates. For a few countries where the official exchange rate does not reflect the rate effectively applied to actual foreign exchange transactions, an alternative conversion factor is used.
World Bank Data as of 2/15/2022: https://data.worldbank.org/indicator/NY.GDP.MKTP.CD
Kharas, Homi. “The Unprecedented Expansion of the Global Middle Class, An Update.” Global Economy & Working Paper 100. Brookings Institution, February 2017. https://www.brookings.edu/wp-content/uploads/2017/02/global_20170228_global-middle-class.pdf.
J.P. Morgan U.S. 2Q 2022, Guide to the Markets, As of March 31, 2022. https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/guide-to-the-markets/