After a volatile 2016, emerging markets continue to offer potential positive performance as well as pitfalls. Despite often being represented in portfolios by a single fund or portfolio allocation, emerging markets are a huge and diverse investment area. In terms of size, emerging and developing economies account for approximately 85% of the global population and 55% of global output when adjusted for purchasing power. They have also accounted for more than 80% of global GDP growth since the 2008 financial crisis according to the International Monetary Fund.
From a diversity perspective, the MSCI Emerging Markets index comprises 832 companies from 23 countries with a market capitalisation of $3.9 trillion. Nowhere else can an investor find exposure to a Russian bull market – up 59% in 2016 – and a slumping Mexico – which fell 9% – in the same year. It is therefore somewhat foolish to consider these markets as a single block and expect to develop a coherent outlook.
Furthermore, investors must remember that they do not invest in economies but rather in the securities of companies and governments. Evaluating investments in this way can highlight both threats and opportunities within the broad universe of options. While many commentators are enthusiastic about the value in emerging markets at a global index level, in reality, these value-driven opportunities appear to be concentrated in a small number of markets.
The Confusing Nature of Emerging Markets
All too often investors get blind-sided by the unintuitive nature of these markets. For instance, while the Indian economy appears to be booming, the Indian BSE stock-market underperformed the emerging market index by 13% over 2016. Conversely, the Bovespa stock-market beat the index by a whopping 54% even as the Brazilian economy contracted.
This plays with investor emotions in peculiar ways. Evidence of the loops and turns emerging markets experience have been especially evident in 2016. Emerging market equity funds started 2016 with continued outflows equating to $11 billion in the nine months to the end of February. The following nine months saw a rebound of $48 billion of new inflows from global investors – the highest inflows since the early 2013 bull market – before sentiment turned again, resulting in $9.3 billion in additional outflows through the end of 2016.
Such rapid changes in sentiment expressed through large capital flows naturally create significant price volatility in the short term. Consequently, if risk is defined as short-term volatility against your reasonable expectations, emerging markets are a crazy place to be.
Applying a Long Term Lens
However, if one defines risk as a loss of future buying power and applies a long-term perspective, the outlook on emerging markets changes. Emerging markets have increased dividends by approximately 312% since the start of 1997 versus just 159% across the global index. When viewed in this light, emerging market shares may appear safer than developed markets in the very long-term.
Digging deeper, the consensus among the investment community is that an investor should demand this extra cash-flow growth premium to buffer against the economic and governance risk that could reduce or eliminate future payouts. As is illustrated below, this premium appears to have deteriorated significantly.
It raises the prospect of whether this is a genuine concern for emerging markets or a potential contrarian indicator. Looking at it from a risk perspective, we can reconsider the above chart in one of two ways: the volatility of outcomes or the worst-case scenario from peak to trough, which is more akin to the permanent loss of capital. The chart below uses a 3-year rolling standard deviation, a common guide to risk, and shows that emerging market dividends are indeed far ‘riskier’ than their global counterparts on this measure.
However, when looked at under a different lens, the worst period of dividend cuts across emerging markets since the turn of the century was during the 2008 financial crisis, exceeding even the Asian crisis of 1998. During this time, dividends were cut from peak to trough by 23% in emerging markets compared to 27% globally. Emerging markets are still capable of a large drawdown in the future, however the comparison can provide perspective to investors that have become overly reliant on volatility as a measure of risk.
What Can Investors Learn?
What is clear is that viewing ‘risk’ as short-term volatility ultimately has the potential to cost people money for three key reasons. First is an opportunity cost. Whenever someone invests in a protection strategy that accepts lower upside to avoid short-term volatility they are not capturing the long-term “miracle of compounding”, as John Bogle, the founder of index giant Vanguard puts it. The second is a matter of value. When the price an investor pays for protection is high relative to the thing they are trying to avoid, the implied probability of the bad thing happening rises; i.e. it costs more to hedge the risk. Paying a valuation premium to remove volatility therefore can seem illogical.
The third relates to how investor demand shifts with recent performance. After steep losses in late 2008, many investors rushed into downside protection strategies in 2009 - akin to shutting the barn door after the horse has bolted. Investors that enter these strategies likely receive much lower returns than those generated by the strategies they left behind. This underperformance comes from the timing of their investments; they’re selling something with a low valuation and buying something that’s probably overvalued.
One rational answer is to focus on the long-term fundamentals which will ultimately drive long-term performance.
Even so, the answer is never straight-forward and requires a fundamental understanding of the risks affecting these markets. Few of the countries covered by the MSCI Emerging Markets index could be described as having mature institutions in stable democracies with a strong legal framework and regulation. As a consequence, the returns that may be expected from companies operating or listed in these markets may be subject to greater uncertainty than equivalent companies in Europe or the United States.
It therefore makes sense for investors to seek a greater margin of safety when investing in emerging markets. However, there are attractive elements to the emerging market story and selected exposure should not be discounted as a destination for long-term capital investment.
A version of this article appeared in International Investment magazine
