In the post-crisis period, as a wave of cash from developed economies’ monetary stimulus washed over emerging markets, investors with healthy risk appetites made fortunes by capitalising on robust growth prospects and attractive yields abroad. From the beginning of 2009 to mid-2011, the MSCI Emerging Markets Index returned approximately 116%, outperforming the S&P 500 by more than 60%.
This golden age for emerging markets was marked by strong growth in China, solid commodity demand and rapid GDP growth across many developing economies. Now the tide is retreating as the Federal Reserve (Fed) has signaled its intent to begin unwinding the unprecedented stimulus of the past four years (provided US economic data continues to be encouraging). With Treasury yields rising sharply in anticipation of a more normalised interest-rate environment, investors are re-evaluating the risk-return profile of their investment options.
The Fed’s timing could not be worse as emerging markets have been hitting some speed bumps of their own: slowing growth in China, weaker commodity demand, and increased political instability. But for those who are willing to sail choppy waters, investment opportunities still exist. As investors shun emerging assets collectively, there are cheaper entry points into markets that exhibit characteristics favouring long-term outperformance.
Despite recent underperformance and the weakening economic prospects of some economies, we view emerging market equities as an important part of a diversified portfolio, for a long-term investor, because of their greater growth potential than developed markets. Emerging economies currently account for 50% of global GDP, a figure that is expected to increase to 53% by 2016. More important, these economies account for 80% of the world’s incremental GDP growth, according to the International Monetary Fund. And, in our view, investors may be under-appreciating the growth potential in some markets based on the gap between the forecast for 2013 economic growth and year-to-date equity market returns.
Opportunities in emerging-market equities should be evaluated on a country-specific basis, as each exhibits its own unique “pull factors” of varying strength. The weakening push of liquidity into emerging economies will expose which markets were most reliant on foreign capital flows, particularly countries with large current account deficits, such as Turkey and South Africa. Emerging markets with lower growth potential, volatile currencies and heightened political uncertainty are also more likely to underperform. In contrast, markets with strong growth potential and healthy domestic consumer demand are more likely to outperform. Southeast Asian markets may also benefit from increased foreign direct investment from Japan. Finally, while commodity exporters have severely underperformed, they may rebound in the long term if the US economy, the world’s largest importer, continues to gather strength.
While we firmly believe emerging market equities offer the potential for attractive returns over the long term, it is important to understand the volatility involved in this risky asset class. It was the worst or second-worst performing in four of the past 13 years, and the best or second best-performing asset class in eight of the past 13 years. It was a middling performer only in one. Over the period, returns, as represented by the MSCI Emerging Markets Index, ranged from negative 53.3% to positive 78.5%. We recommend investors use an active manager to identify the markets with the best return potential.
While the anticipation of the end of QE has substantial implications for emerging market economies, it is but one factor that impacts the performance of this diverse group of markets. The powerful monetary stimulus of developed economies gave emerging market assets a collective push.
As this force abates, investors should focus on the pull factors that will differentiate winners from losers, particularly for equities. While emerging market assets are inherently more risky and volatile than other asset classes, the potential for long-term outperformance remains for discerning investors.
As always, we do emphasise that investing in shares is not for everyone. Their value can fall and you can get back less than you invest – if you are unsure, you should seek independent advice.
:: Andrew Miller, director, Barclays Wealth and Investment Management in Newcastle