Investors worry that emerging market returns have become too correlated to developed market equities. It’s one of two myths that Jennifer Sireklove of Parametric Portfolio Associates aims to dispel.
After a year full of twists and turns, emerging market equities put in a decent showing for 2019. The MSCI Emerging Markets (EM) Index ended up returning almost 19%, only eight percentage points off its historical peak in January 2018. As the decade drew to a close, attention turned to ten-year performance and what that portends for the coming years.
There are two common but contradictory narratives.
The first is that 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.
The second is that emerging market equity returns have become too correlated with developed market returns and aren’t worth the trouble of investing in any more. 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 reach the living standards of developed markets, they could be expected to provide faster growth and, therefore, higher returns. But between downward revisions in the IMF’s annual growth forecasts and a steadily ageing labour force caused by declining fertility rates, some have worried whether this convergence would come to fruition. Besides, a seminal study conducted ten years ago suggested that the link between economic growth and stock market returns might be quite weak. So, perhaps we could dismiss this line of worrying.
Yet there’s a more direct form of the failure of convergence theory: actual stock market returns. Emerging market returns have been weaker than developed market returns over the past ten 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 chart above, if you break out the MSCI World Index into returns for the US and for the rest of the index, it’s less a case of emerging market equities performing dismally than of US stocks performing extraordinarily. Over that same ten-year period, the MSCI EAFE 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.
In retrospect, investors in January 2010 would have been better off putting all their chips on US stocks for the next ten years. For investors in January 2000, however, a ten-year bet on emerging markets would have provided a much better 9.8% annual return, while US stocks actually lost -1% on an annual basis. Once again, we’re reminded that past performance is no guarantee of future results, so we should avoid 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. Correlations have risen since their incredible lows in the early 1990s. But despite a very recent tick upward, if anything, they have actually trended downwards over the past 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.
Now, as we have just argued, one can hardly turn recent trends into reliable forecasts about the future. Over the past ten years, we’ve hardly faced an inexorable increase in correlations. And we suspect that the connectedness of global markets and supply chains may come under additional strain in the near future. We believe that in a less connected world, direct investment across all markets should continue to be an essential approach for a global portfolio.
The bottom line is that 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 should be better poised to harness what the market has to offer in 2020 and beyond.
Jennifer Sireklove is managing director of investment strategy at Parametric Portfolio Associates
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