The selection of Donald Trump as the next US president has caused much head-scratching since election day, not least among emerging market investors with some reconsidering the risk-reward of investing in the developing world. Sceptics believe that Trump’s ‘America First’ policies are either directly hostile in the form of tariffs on overseas goods – the three largest importers to the US are all emerging market countries with China far away the biggest – or likely to strengthen the dollar which could generally harm EM currencies, interest rates and growth prospects.
There are also country-specific threats looming over important emerging markets like China (additional tariffs), Brazil (personal differences between Trump and President Lula) and India (trade and immigration tensions) – three of the original BRIC countries which together represent over half of the MSCI Emerging Markets Index.
Developing doubts
The cautious response to Trump’s victory has seen the EM index drop 2% since election day, whereas the US market has climbed 4% to a new all-time-high[1]. Beneath the surface, however, are countries, sectors and companies that are likely to flourish from the new administration. Turkey, for example, has seen its stock market rise 9% on expectations that it will be a relative trade winner under Trump 2.0.
It also highlights the flaws of investing passively in emerging markets – a grouping of 24 heterogeneous countries that have increasingly more differences than commonalities.
The term ‘emerging markets’ first appeared in 1981 to encourage investment into ‘third world’ economies. The investable universe has changed dramatically since MSCI launched its first EM index seven years later to satisfy investor appetite for exposure to fast-growing countries benefitting from rising living standards and trade globalisation – membership has more than doubled to 24 countries with 26 joining and 12 exiting over the years (Argentina has been in, out, in and out again).
Nowadays, grouping together countries with widely different economic profiles under a single ‘emerging markets’ umbrella makes little sense. Korea and Taiwan, for example, technology leaders which together make up around 30% of the EM index, have already ‘emerged’ on most development metrics. Qatar has higher GDP per capital than the G7 average according to the IMF and is another odd fit alongside far poorer nations in Africa or South America, for example, which may never emerge.
Another downside is that despite its expanded membership, the universe has become increasingly concentrated. China, Taiwan, and India together represent nearly two-thirds (66%) of the index, which is also centred on the information technology and financial sectors that together provide almost half of constituent stocks by weight.
China conundrum
Despite not joining the index until 1996, China has been its largest county representative for over 15 years and now makes up 27% of the investable universe, down from around 40% during COVID but arguably still large enough to distort the index.
Since peaking in February 2021, the Chinese stock market has lost over half its value, putting considerable downward pressure on the broader index which is down by around a quarter over the same period. Indeed, a growing number of investors have sought to exclude China from their EM allocations and data from JP Morgan shows that such funds have received $10bn of net inflows so far this year, exceeding the amount invested in broader EM ones.
Active added value
Developing markets are generally less efficient and liquid than developed ones, making them ideal hunting grounds for stock pickers who can exploit mispricing due to risk-reward imbalances. According to MSCI data, the average EM equity risk premium, defined as the excess stock market return above a risk-free asset, ranged from 31% (Russia) to 8% (Poland) between 1998 and 2020 – double the equivalent range for developed markets – creating huge opportunities for active managers.
This is supported by data from Copley Fund Research on 365 active EM funds which shows average outperformance versus the MSCI EM index in four of the past five calendar years and cumulative 10-year alpha of 10.3%.
In conclusion, the term ‘emerging markets’ which groups together countries from Europe, Asia, South America and the Middle East with disparate economic and return profiles makes little sense. It also ignores their increasingly important role on the world stage and contributes to most investors being underexposed to important markets and companies that will drive future development.
The diversity of emerging markets is also why active managers can generate the best returns. As the new leader of the free world takes office, a selective and nuanced investment approach will be ever more important for the best financial returns to emerge.
By Fredrik Bjelland, Portfolio Manager, SKAGEN Funds Kon-Tiki
