Emerging Markets are up 26% so far year. But can they sustain the rally?
If you invested in one of the large EM ETFs like iShares MSCI Emerging Markets ETF (EEM) or Vanguard FTSE Emerging Markets Index Fund ETF Shares (VWO) ten years ago, you would have earned nearly zero as of September 29, 2017. At the same time, you would have doubled your money if you invested in S&P 500 (SPY) as long as you stayed put during the market crisis of 2008 – 2009.
So is this just a fluke? Or maybe after a lost decade of volatile price swings, EM stocks are finally ready to turn the page. While we recognize the long-term opportunity in EM, we also understand this could be a bumpy ride.
What is an Emerging Market?
In the investment world, the countries are divided into three main categories – developed, emerging and frontier. Developed countries include countries with developed capital markets and relatively high GDP per capita. The list consists of USA, Canada, Japan, UK, Australia, Germany, Italy, France and several others. Emerging markets have some similarities with the developed economies including functioning capital markets and a banking system, but they lack certain characteristics including lower market liquidity and transparency. They also have more political influence and less strict accounting standards.
The list of Emerging economies includes Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey, and UAE.
Just to make things a little more complicated, FTSE indices classify Korea as a developed economy. However, other index providers such as MSCI and Dow Jones include Korea in the EM group.
What makes the emerging markets an attractive investment?
EM has been characterized by higher growth than most developed economies. According to IMF, emerging markets GDP is expected to grow by an average of 4.7% in 2017. Furthermore, despite the recent slowdown, next year projections are the first time in six years when we see an acceleration in the growth forecast.
For comparison, US GDP is expected to grow at 2.6% in the next two years, while EU is projected at 1.7%.
Also, according to World Bank consumption growth per capita in emerging is expected to grow by an average of 5.5% versus 1.5% for developed markets.
This growth differential provides an opportunity for companies with strong presence in these markets to benefit and increase their revenues as a result of the expected economic growth.
According to Euromonitor, developing countries account for 90% of the world population under 30. For instance, the average age of the Philippines is 24, India is 26, Mexico is 27, and Brazil is 31. For comparison, the median age in the USA is 37.2. Japan and Germany are at 46.1. Emerging economies have a young population base which will help them support future economic and consumption growth. In fact, developing markets now account for more than 75% of global growth in output and consumption, almost double their share in just two decades.
With US stocks equities almost fully priced, investors are starting to look for better opportunities abroad. At 16x current price-to-earnings, emerging market equities (EEM) are considerably cheaper than US large cap-equities. For comparison, SPY currently trades at 23.7 times price-to-earnings. Furthermore, Emerging Market price-to-book ratio is 1.63x versus 2.85 for SPY.
Even with the 25% return so far this year, EM stocks are still trading at nearly 50% discount to US large cap stocks. This valuation gap creates opportunities for investors to transfer some of their assets to less expensive assets.
For investors looking to diversify some of their risks, EM represents a compelling alternative. EM stocks traditionally have a lower correlation to the US equity markets.
For instance, a broad EM ETF such as EEM has a correlation of 0.80 to the S&P 500, while its R-squared (explained returns) ratio is 62.7%. As a comparison, a US Small Cap stocks (IJR) have a 0.92 correlation ratio and 78.7% R-squared to the large US cap index.
What are some of the risks?
Volatility of returns
Owning EM stocks comes with a lot of risks. The EM equity performance has been inconsistent for the past ten years. $1,000,000 invested in EEM ETF in Jan 1, 2007 would have produced $ 1,005,620 by Dec 2015 and $1,433,727 by Sep 2017. This is the equivalent of 0.06% and 3.45% annualized rate of return. As a comparison, the same one million invested in SPY would have made 1,735,171 in 2015 and 2,215,383 in Sep 2017 or an average of 6.31% and 7.68% respectively.
This return volatility shows the unpredictability and large swings of returns in EM stocks, which brings us to the next point.
Furthermore, investors who are willing to invest in EM have to stomach the higher volatility associated with these stock. To illustrate, EEM has a beta of 1.29 vs. 1 for S&P 500 and 10-year Standard deviation of 24.59% vs. 15.74% for S&P 500. The maximum drawdown of EEM was -60.44% versus -50% for SPY.
A handful of large corporations and conglomerates are consistently dominating all EM country indices. For example, the top 5 holdings in the China Large-Cap index make up 38% of the entire market. In Korea, top 5 companies make up 33%, with Samsung dominating the market with 20%. In India, top 5 companies’ weight is 36%, in Russia, 35% and Mexico, 40%. As a comparison, top 5 stocks in the S&P 500 index (SPY) make up 11% of the total.
This high concentration leaves the Emerging markets exposed to the fortunes of the handful of companies dominating their markets.
Another risk associated with emerging economies is their heavy dependence on local politics. Just in the past few years, we saw North Korea nuclear threats, political scandals in Brazil, sanctions against Russia, the war in Syria. Changes in political power or any geopolitical turmoil will significantly impact the emerging economies and their neighbors.
Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is a sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing.
Disclosure: I am/we are long VWO, EEM, SPY, IJR.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.