After a year full of twists and turns, emerging market equities put in a decent showing for 2019.
The MSCI EM Index ended up returning almost 19%, only eight percentage points off its historical peak in January 2018. As the decade draws to a close, attention has turned to 10-year performance and what that portends for the coming years.
There are two common, but contradictory, narratives:
- Emerging market equity returns have disappointed in comparison with developed market returns and therefore are likely to disappoint in the future. In other words, they’ve become very different from developed equity markets, but in the wrong direction.
- Emerging market equity returns have become too correlated with developed market returns and aren’t worth the trouble of investing in anymore. In other words, they’ve become very similar.
We believe both narratives are false and fail to help investors discern what the next year, to say nothing of the next decade, may bring.
Myth #1: The failure of convergence
The first narrative revolves around the theory of convergence. As emerging markets reached the living standards of developed markets, they were expected to provide faster growth and, therefore, higher returns. But between downward revisions in the IMF’s annual growth forecasts and a steadily aging labor force caused by declining fertility rates, some worry whether this could actually come to fruition.
Of course, even with more conservative projections, emerging market economies are still growing faster than developed economies and have cheaper labor market costs on average. Besides, the link between economic growth and stock market returns has been found to be quite weak. So this line of worrying is more easily dismissed. But there’s a more direct form of the failure of convergence theory: actual stock market returns.
It’s true that emerging market returns have been weaker than developed market returns over the last 10 years as a whole. Annual returns over this period were 3.7% for the MSCI EM Index compared with 9.5% for the MSCI World Index. Case closed? Not so fast. As you can see in the below chart, if you break out the MSCI World Index returns into that for the US and the rest of the index, it’s less a case of emerging market equities performing dismally than of the US performing extraordinarily. Over that same 10-year period, the MSCI EAFESM Index returned 5.5% compared with 12.9% for the MSCI USA Index, which was similar to the more widely followed S&P 500® Index over that period.
Annual returns for two recent decades
Sources: S&P, MSCI, Parametric, 2019.
For illustrative purposes. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
Clearly, if this were January 2010, we’d all be better off putting all our chips on US stocks for the next 10 years. But what if it were January 2000? A 10-year bet on emerging markets would have provided a much better 9.8% annual return, while US stocks would have actually lost -1% on an annual basis. Yet even though we all know that past performance is no guarantee of future results, we just can’t resist extrapolating future trends based on recent results.
Myth #2: Rising correlation
The second narrative stems from a very different worry. In this case, instead of focusing on how different emerging market and developed market returns have been in recent years, observers are worried that they’ve become too similar and more highly correlated than ever before. In this view, emerging market investments may no longer be valuable from a diversification perspective, especially if one can simply buy developed market companies doing business in emerging markets.
The rebuttal here is more straightforward. As the below chart shows, correlations have risen since their incredible lows in the early 1990s. But despite a very recent tick upward, if anything, they have actually trended downward over the last ten years. Equity market returns naturally have a high degree of correlation, especially as markets have become more connected over the decades. But with correlation levels around 0.7 to 0.8, it hardly seems that emerging market equities and developed market equities have become interchangeable.
Rolling three-year correlation
Sources: MSCI, FTSE, Parametric, 2019.
For illustrative purposes. Not a recommendation to buy or sell any security. It is not possible to invest directly in an index.
Now, as we just argued above, one can hardly turn recent trends into reliable forecasts about the future. But it seems hard to argue that we’re facing an inexorable increase in correlations, especially if the connectedness of global markets and supply chains comes under additional strain. In a less connected world, direct investment across all markets would continue to be an essential approach for a global portfolio.
The bottom line
Since they represent more than half of the world’s economic activity, emerging markets are simply too big to ignore. And if history is any guide, the good news—and the bad—is likely to come from wherever we least expect it. But if we remain invested across a broad range of countries and companies, we’ll be better poised to harness what the market has to offer in 2020 and beyond.
Potential Parametric solution
