Emerging market equity ETFs have seen a flood of investor interest in 2010, ranking just behind physical gold products in terms of year-to-date net cash inflows with just shy of EUR 3.6 billion being added to these funds through the end of October, according to our ETF flows estimates. A large proportion of these flows went into products tracking the performance of the MSCI Emerging Markets Index, which includes equities from 21 different emerging economies. The BRIC (Brazil, Russia, India, China) nations account for about half the index's value, and South Korea and Taiwan comprise another one-quarter. In the past decade, where developed equities had stagnant performance, burgeoning investor interest in emerging markets was rewarded; the index returned 180% in euro terms through the third quarter of 2010, compared to -10% for the developed market MSCI World Index. But is the trend sustainable, or are investors making the typical mistake of chasing yesterday's winner?
Year-to-date, the MSCI EM has outperformed the MSCI World by about 850 basis points, so investors have been compensated for the additional risk that an emerging markets investment entails. In fact, because emerging and developed markets are not perfectly correlated, adding exposure to emerging markets can actually reduce overall portfolio risk. However, the diversification benefits of adding emerging markets exposure appear to be decreasing, as the correlation between emerging and developed markets has increased over time. For instance, the correlation between the developed market iShares S&P Global 100 ETF and the iShares MSCI EM was only 0.48 in 2007, but increased to 0.68 in 2008, and then to 0.83 in 2009 and so far in 2010.
Proponents of the emerging markets investment thesis will often point to higher expected growth rates when compared to the slow-to-non-existent growth in Western Europe, the US and Japan. In 2009, in the midst of the worst recession in recent memory, the BRIC economies generally performed very well, with the notable exception of Russia. Brazilian GDP growth clocked in at 2%, and India and China’s economies expanded by 7% and 9%, respectively. Meanwhile, the developed world bore the brunt of the downturn. Growth was an anaemic 0.1% in the US, while the UK economy shrank by nearly 3% and Japan’s GDP fell by 5%. Most economists forecast a persistent disparity between the growth rates of developed and developing economies over the next few years.
While few would argue with this prognosis, investors are ultimately buying into the expectation for future stock market growth, not GDP growth. And contrary to popular belief, the two are often unrelated. While it may seem counterintuitive that a nation's stock market may not necessarily benefit when GDP growth is strong, the historical evidence points to a weak correlation between the two factors. In a study of the linkage between economic expansion and the health of equity markets, University of Florida finance professor Jay Ritter compared the market returns and GDP growth of 32 countries from 1970 to 2002, and concluded that there was little correlation between the two variables. For example, the Swedish equity market posted average annual returns of greater than 8% during the period in question, while the Nordic nation's GDP compounded at less than a 2% annual rate. And the opposite is equally true; strong GDP growth doesn't guarantee strong equity returns. South Korean GDP grew more than 5% per year from 1988 to 2002, while its stock market registered annualised returns of just 0.4%.
Why might stock market returns lag (or exceed) GDP growth rates by such a large margin? There can be any number of possible explanations, but let's focus on three main reasons: microeconomics, market expectations, and valuation.
Microeconomics
While the macro-economy can be firing on all cylinders, it doesn't necessarily help individual companies. Sure, there may be a broad-based increase in demand for products and services, but there will also likely be increasing competition for those sales, as well as for production inputs such as labour, raw materials and capital. The structure of any particular industry, and the competitive advantages companies can carve out of that structure, are far more important to an individual firm’s fundamentals and long-run equity returns than domestic demand growth.
Furthermore, not all equity markets are geared towards domestic demand. The Brazilian equity market is dominated by companies like Petrobras and Vale, which depend on global demand for their product. Of course, this also works the other way, and plenty of multinationals headquartered in slow-growing developed nations will benefit from phenomena such as the rise of the middle class in emerging markets. Household products behemoth Unilever is a prime example of the latter case.
Market Expectations
Equity markets are inherently forward looking, discounting the aggregate of investors’ expectations for the future. As such, market expectations of future economic performance often matter more than an economy’s actual performance. If China grows 6% next year, the UK may look on in envy, but investors in Chinese shares will likely be disappointed as they expected a higher growth rate. Conversely, if UK economy grows at a 4% rate in 2011, investors will be pleasantly surprised. The actual level of growth matters only in relation to expectations, which is closely related to our next point.
Valuation
The most important determinant of investment returns is the valuation level where the initial purchase was made. If a country's stock market is trading at a price-to-earnings ratio of 35, then the country may need a decade of robust GDP growth to justify that multiple. Any slip-up relative to the lofty expectations implied by a P/E of 35 will likely be met with a re-valuation (in the form of multiple compression) as the market re-evaluates its prior expectations, hurting returns markedly.
So how are the valuations for emerging markets right now? Based on a look at the trailing-12-month price-to-book, price-to-cash-flow and price-to-earnings ratios for the MSCI EM index, emerging markets are trading right in line with their five-year averages. They are also trading relatively close to developed markets on those measures. However, emerging economy stock markets traditionally traded at a lower earnings multiple than their developed counterparts, in part to compensate for higher political and legal risks. That lower valuation generated higher dividend yields and higher returns relative to developed markets, helping compensate for the risks of shabby treatment for foreign minority shareholders. That risk may be lower now that emerging markets have come of age, but then the excess returns that compensated for that risk are also likely to be history. Whether emerging markets looked overvalued compared to the past, or just less risky than before, the end result is that we do not expect higher returns over the long run from today’s prices.
So while investors should allocate a portion of their portfolio to emerging markets, it's hard to recommend overweighting the sector. In contrast, investors in emerging markets at the turn of the century were buying in at a relatively low price-to-earnings compared to developed markets, which largely explained their subsequent 10-year outperformance. In our next article, we'll look at investing in particular corners of the emerging markets for greater reward potential.
