Fundamental advantages of emerging market equities

Buying emerging market (EM) equities can improve the outcome of an investor’s global equity allocation. EMs demonstrate higher GDP growth than developed markets (DM), which translates to higher earnings growth and – over the long term – higher total return to the equity investor. However there are periods in which one asset outperforms the other and the disparity between the two can swing significantly in a short period. Maintaining an EM exposure as part of the global equity allocation removes the need to attempt timing shifts between the two and over the long-term delivers a superior outcome to a solely DM exposure.

i) EMs deliver higher GDP growth

EMs are not homogenous and the countries within the universe exist right along the spectrum of economic development. Levels of GDP growth in EMs can also be more volatile than in developed. Nevertheless, it is possible to demonstrate that there are generally higher levels of GDP growth in EMs, given less mature economies. The IMF’s growth projections are shown in Figure 1.

 

 

 

 

 

 

 

 

 

ii) Higher GDP growth translates to higher equity market returns

There are ultimately two drivers of equity returns: earnings growth and valuation. Valuations can have a significant impact in the short-term, but are ultimately mean-reverting. Over the long term, however, it is earnings growth which has the greatest effect upon equity returns. The ultimate effect is that – contrary to a common misconception – over the long-term there is an observable and positive relationship between GDP growth (via the medium of growth in corporate earnings) and equity market returns for almost all EMs (Figure 2).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The upshot is that, at an index level, EMs have delivered superior returns to DMs over the last twenty years, as demonstrated in Figure 3. Over this period, the average calendar year return for MSCI Emerging Markets has been 9.13% versus 6.56% for the MSCI World – a difference of 2.57% pa (all AUD). In US dollars, MSCI Emerging Markets has returned 12.39% pa, versus 7.83% for MSCI World, a difference of 4.56%.

 

 

iii) Differing growth profiles brings benefits from diversification

Emerging and developed markets have historically displayed different growth profiles. For example, in the period from 2001 to 2007 EMs significantly outperformed DMs. However, more recently, from 2001 to 2015 it has been the other way round. These periods have often included a ‘stand-out’ year where one asset has significantly outperformed the other – such as 2005 and 2009 for EMs and 2008 and 2013 for DMs. Crucially, relative performance between the two can swing quickly. For example, EMs significantly underperformed DMs by 20.9% in 2000, then outperformed by 15.4% the following year. Likewise, in 2008 EMs underperformed DMs by 16.1%, then swung about to outperform by 37.4% the following year (all figures in AUD).

Maintaining an exposure to EMs as part of a global equities allocation removes the imperative to try to time these significant and often swift swings in sentiment. Figure 4 demonstrates that a simple 50/50 split between MSCI World and MSCI Emerging Markets would have delivered a significantly higher return, at a very small increase in risk, than a purely developed market portfolio over the last fifteen years.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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