Who’s Afraid of an Emerging Markets Meltdown?

Deep declines are usually followed by rebounds that leave emerging market stocks with gains by year end, as the structural tailwinds are driven by steadily expanding middle classes. Meaningful, consistent exposures to the asset class are key to capitalizing on the long-run double-digit returns. 
 

Botafogo district and Dona Marta favela, Rio de Janeiro, Brazil

The term “emerging markets” has long seemed a bit off given the volatile behavior of these markets. After climbing 84% from its January 2016 low to its January 2018 peak, the MSCI Emerging Markets Index has dropped around 20% over the last eight months. Should we expect emerging markets to grow into developed markets at some point? Certainly, but over time. 

While the East Asian city-states of Hong Kong and Singapore long ago emerged as developed, it may seem that most have been “emerging” for decades now and are no closer to developed-market status today than when Neil Armstrong landed on the moon. Yet a number of emerging markets have shown remarkable improvements in growth and stability, from South Korea and Taiwan, to Chile and Colombia, Poland and the Czech Republic, to the world’s largest fast-growing economies, India and China. 

The term emerging markets was initially coined by Antoine van Agtmael during an investor conference in Thailand in 1991. He aimed to differentiate a subset of promising developing countries from a much larger group collectively referred to as the “Third World.” Beyond the designations, though, many are investment-worthy countries that sport middle- and high-income economies. The former, according to the World Bank, have per capita gross national income (GNI) of $3,896 to $12,055, while the latter’s per capita GNI is $12,056 or more. 

And more importantly, most are growing faster than developed economies. In 2017, they received roughly two-thirds more foreign direct investment than they shipped out, as local market-friendly regulation, such as time required to start a business, has steadily improved over the years. Moreover, developing countries are home to a growing number of world-class companies. One key differentiator relative to developed countries is the uneven distribution of national wealth: most people in these countries live in poverty but aspire to a middle-class lifestyle. Hundreds of millions of people in both China and India have already entered the middle class, and hundreds of millions more are expanding the middle-class ranks in other emerging markets. This dynamic will continue for decades to come, as four-fifths of the global population reside in developing countries. 

Doubtless there will be plenty of bumps and heightened volatility along the way. The Trump administration has escalated its tariff battle with Beijing and slapped sanctions on Venezuela, Turkey, and Russia. Rising U.S. rates have generated additional pain for most emerging market (EM) currencies, particularly those made more vulnerable due to current account deficits or heavy dollar-denominated debt loads in their domestic markets. Following strong foreign investment from January to April of this year, May through August showed a clear change in sentiment. Foreign direct investment went from record highs earlier in the year to negative in June and then only slightly positive thereafter. That reversal, along with the rise in U.S. rates pulling portfolio flows back into the greenback, largely explains the selloff in emerging market stocks and bonds. 

While this has been painful for those invested in EM, the experience is not exactly unusual for the asset class. Over the last 15 years, the MSCI EM Index pulled back 15% or more 11 times, and it still finished the year higher six of those 11 times.

Investors who held on through the turbulence have been well compensated for the rough ride, and not just in terms of portfolio returns. Emerging markets not only provide a rich array of opportunities but do so with low correlation to the U.S. market. How? Those world-class companies and the ability to leapfrog technological and economic stages.

Take, for example, the world’s largest retailer. It’s not Amazon, eBay, or Walmart. It’s China’s Alibaba, which by sales is larger than the three U.S. companies combined. Alibaba is also growing at a faster rate than Amazon and the stock trades at a much lower price-to-earnings multiple.

Digital payments companies offer another unique opportunity. Many emerging markets are in the early stages of moving from cash-based purchases to digital payments, but at a much faster pace relative to developed markets. In China, Brazil, India, Thailand, and elsewhere, massive waves of people are moving quickly toward cashless payments. Alibaba, it should be noted, owns mobile payments provider Alipay. See charts below on China’s growth in payments and Alipay’s share. Also, China has already surpassed the U.S. in mobile payments. 

Investors would be well advised to maintain balanced, meaningful exposures to the developing world. Online shopping, experiential consumption such as tourism and the associated airline travel, retail banking, and many other opportunities are growing rapidly across emerging markets, all driven by fast-expanding middle classes. Capturing these trends while working to avoid the individual blowups and protect on the downside when emerging markets swoon isn’t, of course, easy. But portfolios populated with well-managed businesses that are growing rapidly, yet not overly burdened by debt or directly subject to hard-to-predict political outcomes make for a smoother, more profitable ride, in our experience. That’s because the strong businesses in each developing country are often positioned to withstand the ups and downs that have become commonplace in their home markets.

What’s the end result? The long-term returns in dollars are greater than 10% per year in the MSCI EM Index since its 1988 launch. To be sure, many emerging market investors don’t receive that return if they’re trying to time their exposures to the asset class: Morningstar’s investor returns of just 6.5% for the trailing 15 years versus 9.1% annually for category funds during that period. 

Skittish emerging market investors should keep that differential in mind as they see the headlines on China’s stock market declines this year. There’s reason for optimism about the prospects for many companies in the world’s second-largest economy, which grew an annual 6.7% in the second quarter. Chinese stocks now exhibit a nice combination of attractive earnings growth and valuations. Investors concerned about U.S.–China trade jousting should appreciate the levers that China can pull to sustain its economic growth and remember that China is generally a reliable catalyst for broader sentiment toward emerging markets. All that suggests that this year’s drop in emerging market assets can make for a highly attractive entry point on a multi-year view.

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The performance of any index is not indicative of the performance of any particular investment. Unless otherwise noted, index returns reflect the reinvestment of income dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. Investors may not make direct investments into any index.

The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI Emerging Markets Index consists of the following 24 emerging market country indexes: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, South Africa, Taiwan, Thailand, Turkey and United Arab Emirates.

The MSCI Emerging Markets (EM) Currency Index tracks the performance of 25 emerging-market currencies relative to the U.S. Dollar.

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