Why emerging market equities deserve a fresh look

Investors have long had a fascination with emerging markets and their prospect for higher growth rates, leading to a variety of investments in everything from bonds and equities, both public and private, to real estate, infrastructure and agriculture.

Emerging market equities haven’t delivered on their expected promise, underperforming developed markets in the five-year period ending December 2016. Developed equity markets, as measured by the MSCI World Index, returned 17.3 per cent to Canadian investors during that time period. Emerging market equities, as measured by the MSCI Emerging Markets Index, returned 7.4 per cent. 

Falling commodity prices, political uncertainty and, in some countries, corruption, combined with slowing growth, contributed to the relatively poor showing of emerging markets. However, it’s worth noting that in 2016, emerging market equities performed better than their developed market cousins, returning 8.6 per cent to Canadian investors, versus the MSCI World Index’s return of 4.3 per cent.

Read: Emerging Asian markets expected to grow amid volatility: report

The question that naturally follows is whether the time has come for emerging market equities. If so, what has changed compared to the last five years?

A recent study published by PricewaterhouseCoopers noted the economic might of the emerging economies will far outstrip that of the developed economies. At present, for example, the United States contributes approximately 20 per cent to global gross domestic product on a dollar-weighted basis, compared to China’s shared of about 13 to 14 per cent. The accounting firm noted that on the basis of purchasing-power parity, China has already surpassed the United States. In fact, it projects China will be the largest economy by all measures in 2050, with India expected to rank second and the United States third. The European Union will decline to nine per cent of global GDP in 2050 from its current 15 per cent on the basis of purchasing-power parity.

On a per-capita basis, U.S. GDP was four times that of China’s in 2016 and almost nine times that of India’s. By 2050, that gap will narrow substantially with U.S. per-capita GDP projected to be only two times that of the China and three times India’s. That’s due, in part, to population growth in India and a larger workforce and increased domestic demand in both countries.

Read: The growing attraction of Chinese real estate investments

Expected equity returns over the next 10 years reflect the enhanced prospects for emerging versus developed markets, which are struggling with a maturing workforce, lower worker participation rates, higher pension and health-care costs and, subsequently, lower output. The 10-year annualized expected geometric return for U.S. equities is approximately six per cent, compared to 7.6 per cent for emerging markets. Canadian equities fare marginally better at an expected 6.3 per cent.

From a Canadian perspective, emerging market equities have been a difficult sell because of the high correlation of returns between the S&P/TSX Composite Index and the MSCI Emerging Markets Index. From 2005-14, the correlation ranged between 60 per cent and 85 per cent and was more than 80 per cent for much of that period, according to Bloomberg, BlackRock and MSCI.

The composition of the Canadian and emerging market indices has also been similar, with energy, materials and financials accounting for more than half of the market capitalization. The Canadian dollar has tended to trade in tandem with emerging market currencies, with both influenced by the price of oil.

Read: The three trends that will affect the economy in 2017

More recently, the correlation of the S&P/TSX Composite Index and the MSCI Emerging Markets Index has softened to about 60 per cent in 2016. Also, the composition of the indices has started to diverge. For example, information technology companies account for less than five per cent of the S&P/TSX Composite Index, whereas they represent more than 20 per cent of the MSCI Emerging Markets Index.

As has always been the case, investors should tread carefully in emerging markets, since there can be significant differences between them. For example, the rule of law in India is far different from the situation in Russia.

Finally, investors need to decide whether they want to make a standalone allocation to emerging market equities or invest through their global or international equity managers. There are arguments in favour of both approaches, so understanding them will help in deciding which approach makes the most sense for each investor.

Whichever approach an investor takes, one thing is clear: Emerging market equities deserve a fresh look.

Janet Rabovsky is a partner at Ellement. She has more than 25 years of experience in the industry. These are the views of the author and not necessarily those of Benefits Canada.