Emerging markets offer dubious investment appeal

LONDON, May 12 (Reuters Breakingviews) – U.S. stock markets are falling, but stocks in developing economies have fallen just as quickly. Since the beginning of the year, the S&P 500 index of large US companies is down 17%; the MSCI Emerging Markets index has fallen 18%. This basket of shares, which contains shares of companies from Brazil to the United Arab Emirates, now looks relatively good value. Investors who bought these stocks when they were cheap at the turn of the century enjoyed excellent returns. Unfortunately, the growing weight of China suggests that the happy experience will not be repeated.

In the early 1980s, Dutch economist Antoine van Agtmael wanted to launch a “Third World Investment Fund” but was told the name wasn’t catchy enough. So he came up with the more optimistic “emerging markets.” In 1985, the first index tracking these stocks was launched. A couple of years later, MSCI created its own benchmark. Fund managers promoted the new asset class with the promise that higher rates of economic growth in the developing world would be accompanied by superior returns from stocks. In 2001, Goldman Sachs forecast that the economies of Brazil, Russia, India, and China (the BRICs) would overtake the developed world within decades. Van Agtmael praised the “emerging markets century”.

The problem with this idea is that there is no correlation between economic growth and stock returns. In theory, in a world with free capital flows, shareholder returns from different stock markets should converge. Historical data from various countries since 1900 confirms that investors have not been better off choosing markets with the highest economic growth.

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In fact, the opposite has happened. In the short term, the countries with the fastest GDP growth have tended to generate the lowest returns, while the economically lagging countries have done best. Look at China’s recent experience. In the last three decades, China’s GDP has multiplied by more than 30 in US dollars. However, during this period, the total return on Chinese equities averaged just over 2% per year, again in dollar terms.

Van Agtmael was on firmer ground when he argued that investing in emerging markets would diversify portfolios, reducing risk and improving returns. According to MSCI, the one-year correlation between emerging and developed markets is around 0.4, slightly below its long-term average. Markets moving in perfect unison would have a correlation of 1. Adding emerging stocks to investment portfolios has paid off. Since the turn of the century, the MSCI Emerging Markets Index has marginally outperformed the benchmark MSCI World index of developed markets.

The problem is that emerging markets are no longer as diverse as they used to be. China, which was not part of the original van Agtmael index, now accounts for around 30% of the MSCI benchmark index. Therefore, future investment returns from emerging markets now largely depend on what happens in the People’s Republic.

There are reasons for pessimism on this front. Investors only thrive in countries where the rule of law prevails. Yet shareholder rights count for little in modern China. Last year, in the name of “common prosperity,” President Xi Jinping went after Chinese education companies, real estate companies, and tech giants. The president’s taste for absolute control has been reflected in China’s zero-Covid policy, which recently resulted in a new round of rolling lockdowns and economic disruption across the country.

To some extent, these risks are reflected in current valuations of emerging market equities, which trade at a significant discount to Western equities. But investment strategist John-Paul Smith, who started managing an emerging-markets fund in 2001, suggests the opportunities on offer today aren’t as enticing as they were two decades ago. At the time, my former employer, asset manager GMO, forecast that emerging market stocks would generate real annual returns of nearly 8% for years to come. That prediction turned out to be remarkably accurate. GMO’s most recent forecast is for emerging markets to return only half that amount.

What made emerging-market stocks such a good bet at the turn of the century, Smith says, is that the Asian financial crisis of the late 1990s prompted a series of macroeconomic and microeconomic reforms. Governments were forced to control public spending. Banking regulations improved and bankruptcy rules were more strictly enforced, driving weaker firms out of business. Emerging markets seemed to be adopting the Anglo-Saxon model of capitalism. Over the last decade, however, they have moved in the opposite direction. State capitalism, says Smith, is the kiss of death for investors. Creative destruction is not a political option.

What should investors do? Smith believes that the concept of emerging markets as a separate asset class is outdated. In his opinion, it was always a marketing device to attract investors to funds that charged higher fees. He suggests that emerging market investments should be integrated into global equity portfolios. At a minimum, they should be renamed “less developed markets” to alert investors to their generally weak governance and lack of liquidity.

Russia’s recent exit from the Western financial system shows that emerging market investors face the occasional prospect of complete demise. This was not an isolated event. Russian shareholders lost everything in the 1917 revolution, as did Chinese shareholders when the communists took power in 1949. Japan’s stock market fell 98% in real terms during World War II. A study by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School shows that emerging market investors never fully recovered from these devastating losses.

At the time of the Ukraine invasion, Russian stocks accounted for about 2% of the emerging market index. Such loss can be easily absorbed. But China’s weight in the benchmark index is 15 times higher. Given the mounting political tension, foreign investors cannot completely ignore the risk of losing their shirt in China.

Therefore, some emerging market investors are choosing to write China out of the picture. The Ex-China Emerging Markets Index is a more balanced portfolio with less geopolitical risk but no apparent sacrifice in prospective returns. In the investment world that’s called a no-brainer.

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(The author is a columnist for Reuters Breakingviews. The opinions expressed are his own.)

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Edited by Peter Thal Larsen, Streisand Neto and Oliver Taslic

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