Emerging markets: is investor sentiment about to turn?
Emerging markets have seen greater volatility than developed markets over time, but over the current cycle investors have not been rewarded for taking on this additional risk.
Emerging Markets beaten by inflation
Total return data since 1995 show a disparity of returns across different regions of the world - from a +919% return in US stocks, to a disappointing +57% return in Japanese equities.
While cherry-picking a start date to create a story is common practice in the world of financial journalism, we believe this time frame offers enough data to observe long-term trends. It also includes three of the large downturns in recent history, which typically see valuations reset to more 'normal' levels.
Figure 1: Total returns, denominated in USD (28 February 1995 – 31 May 2019)
Figure 1 above shows how emerging market (EM) stocks have been a relatively poor choice of investment over the last 25 years, with only Japanese shares performing worse.
EM stocks surged in the run up to 2008 and rebounded impressively over the three years following the last financial crisis. But since 2011, they have been a disappointing investment - EM stocks have returned an annualised rate of just 2.0% while global inflation has averaged 2.8% per year.
Over the same period, US stocks have averaged a 14.5%, while European, Japanese and UK mean returns were +9.0%, +7.5% and +9.6%, respectively.
Should Emerging Markets provide greater returns?
Investors take on investment risk in hope of being rewarded with returns that exceed the risk-free rate of return. When investing in overseas stocks, you not only take on company-specific risks, but also expose yourself to the economic, currency and political risks for the country in which the company operates. EMs are perceived to be riskier than developed markets (DMs), and so it is reasonable to expect higher returns over time.
But over the last 25 years, EM investors have not been sufficiently compensated for the higher risk that EM equities exhibit. Both the Sharpe and Sortino ratios can be used to compare risk-adjusted returns across different regions of the world.
Figure 2: Risk-adjusted total returns, USD (28 February 1995 – 31 May 2019)
|MSCI USA||MSCI UK||MSCI Europe ex UK||MSCI EM||MSCI Japan|
Source: MSCI, IG
The Sharpe ratio is a metric used to measure how well investors are compensated for taking on investment risk. The higher the Sharpe ratio the better.
The Sortino ratio can also be used to compare risk-adjusted returns. However, the Sortino ratio only considers downside risk in its calculation of standard deviation. Upside volatility is removed as this should be viewed as favourable to investors. Looking at both the Sharpe and Sortino ratios in the table above - EMs have underperformed the US, UK and Europe on a risk-adjusted basis since 1995.
Emerging Markets have seen larger, more frequent declines
EMs have also seen more frequent and aggressive drawdowns than developed market indices. Figure 3 shows the percentage decline from the previous peak for both the MSCI World index (contains developed equities only) and the MSCI Emerging World index.
Figure 3: Drawdowns for MSCI World and MSCI Emerging Markets
The additional risks that EM stocks exhibit can be illustrated by the sharp drawdowns (green line) in the EM index at the same time that the MSCI World index is impacted by a lower extent.
In 1997, a number of South-East Asian economies were rocked by a financial crisis which later spread to other parts of the emerging world, hurting economies with large current account deficits the most. This was swiftly followed by the Russian debt default in 1998, which saw the Moscow Stock Exchange plunge by over 83%.
These events combined caused a 56% drawdown in the EM index by August 1998 and it wasn’t until February 2004 when these losses were recovered. However the impact on DMs was a less severe 14% decline which was reversed in full over the following seven months. Back then, correlations between EM and DM were lower at around 40%, compared to 87.5% today.
Why have Emerging Markets underperformed over the last decade?
The composition of the MSCI Emerging Market Index has changed considerably since the EM-specific crises in the 90’s. In 1998, Brazil held the largest weight with 11.9% of the index. Today, China holds a much larger stake with 28.1% while Brazil has seen its share fall to 7.3%.
The rise of China’s presence in the EM index has coincided with a gradual slowdown in the Chinese economy, which in turn has weighed on EM returns. The high and growing exposure to China leaves the index vulnerable to shocks to the world’s largest economy based on purchasing power parity. A recent example of this was the 2015 panic-driven stock market crash, where Chinese equities lost 42% between April 2015 and February 2016, leading the MSCI EM index down 31%.
A major headwind to EM returns is the US-China trade war. While the US economy remains robust for now, economic data from China continues to paint a picture of slowing growth. But as US president Donald Trump is seeking re-lection next year, both camps have strong incentives to resolve differences to provide a fillip to their economies.
And it is not just China who President Trump is looking to go head-to-head with to strengthen the position of the US, other EM economies are being sucked into the trade war. Trump recently called out Mexico on failing to stem immigration into the US and also India on its relatively high tariffs on US goods.
As a gauge of current sentiment on the EM equity market, a useful tool is BlackRock’s geopolitical risk dashboard1 which gives their top ten risks to global equity markets. All but European fragmentation can be argued to directly affect EMs.
Figure 4: BlackRock’s Top 10 risks to global equity growth
|Global trade tensions|
|South Asia tensions (India/Pakistan)|
|Latin America policy|
|North Korea conflict|
|Major terror attack|
BlackRock’s global risk index is currently at its highest level on record with a score of 3.71, which implies that the level of geopolitical risk is currently 3.71 standard deviations above its long-term average. This is an extreme level by historical standards, which could suggest that the worst is already priced into EM equity markets. A contrarian investor may even use this as a potential buying opportunity in EM stocks.
Figure 5: BlackRock geopolitical risk index
In a follow up article we will look at EM equity valuations to assess whether EMs present a long-term buying opportunity.