Emerging markets: A risk worth taking?

Krishna Memani, Chief Investment Officer at Oppenheimer Funds

June 2018 

Key Points

  • Positive secular forces, like a growing labor force and expanding middle class, are broadly fueling growth for emerging markets
  • The cyclical case for emerging markets is supported by improving economic growth, declining inflation and attractive equity valuations
  • Emerging markets could be viewed as a portfolio growth engine, yet this asset class can experience higher levels of volatility

Emerging markets have drawn increasing interest from investors in recent decades due to the rapid growth of economies that make up this asset class, most notably China and India. Smaller countries in Eastern Europe and Latin America have also demonstrated impressive growth during certain periods. Investors have benefited from significant returns over time but have also experienced periods of dramatic volatility. 

In late June, the MSCI Emerging Markets Index was lower by 5.6% year-to-date (compared to the S&P 500 +3.5%). This drop was due, in part, to rising interest rates in the U.S., a stronger U.S. dollar and increased trade tensions. These headwinds could continue, at least in the short-term. 

The emerging market strength potential

Investors may recall a time when the world’s market prognosticators were raving about the growth potential of emerging markets. Citizens of countries such as China, India, Vietnam, and Indonesia — roughly 40% of the world’s population — were increasing their wealth levels to middle-class status in a fraction of the time it took those in developed markets to do so. The working-age population in the emerging markets was also poised to surge from 1.5 billion to 4.0 billion by 2035.

Economists were forecasting that by 2035, the output of the world’s emerging economies would surpass that of the developed world. China was predicted to supplant the U.S. as the world’s largest economy. 

 

Market returns validated investor optimism. From 2000 to 2012, emerging market equities outperformed U.S. equities by more than 7% per year.1 That’s almost 200% of cumulative outperformance during that period. 

Emerging markets pull back

Between 2013-2015, investors learned that there is still no cure for the common business cycle. The positive secular forces for the emerging markets — a growing labor force, an expanding middle class, and companies moving up the value chain — have not changed.

During this time, emerging market assets suffered from a series of macro headwinds, including:

  • Weaker global growth
  • Sharp declines in emerging market exports
  • Collapse in commodity prices
  • Falling currencies
  • Rising inflation
  • Capital flight as U.S. monetary policy conditions normalized

As Mark Twain said in response to rumors about his death, the decline of emerging markets was being greatly exaggerated.

Back to the economic basics

By early 2016, the tide began to turn. The cyclical case for emerging market assets was (and still is) supported by:

  • Improving economic growth
  • Rapidly declining inflation, which has provided cover for policymakers to support economic growth
  • Attractive equity valuations and higher real bond yields compared with the rest of the world
  • Currencies trading at steep discounts to the U.S. dollar, boosting emerging market exports and providing a potential tailwind for dollar-based investors 

If favorable trends persist

Markets responded favorably, with the broad emerging market index2 gaining 78% in U.S. dollar terms (compared with 49% for the S&P 500® Index) from the cyclical low in January 2016 through the end of 2017. Emerging market stocks continued to perform well in the early months of 2018.

The economic backdrop matters for emerging market stock returns. The current environment, including a stable U.S. dollar plus widening U.S. deficits and massive U.S. fiscal expansion, will likely contribute to an environment that resembles 2003-2006 more than 2013-2015.

In recent weeks, emerging markets have sold off amid a confluence of factors:

  • Idiosyncratic events in Turkey and Argentina
  • Tighter Fed policy
  • Concerns over the U.S. administration’s trade policy

We agree that if the Fed tightens too aggressively or the administration goes too far with trade actions, then the dollar will rally and emerging market assets will underperform.  Fortunately, we believe there is an alternative, and more likely, path as cooler heads prevail on trade and U.S. fiscal stimulus leaks to the rest of the world, particularly emerging markets.

It is likely, for example, that a good portion of recent fiscal stimulus, in the form of lower taxes for individuals and corporations, will find its way to emerging market goods and services. In turn, those countries can be expected to invest at least some of the proceeds in U.S. Treasuries.

This could create an environment very similar to what we saw in the mid-2000s. While the future is not predictable, the groundwork has been laid for a favorable scenario for investors in emerging markets. 

An attractive opportunity

Emerging market valuations remain attractive by almost all metrics. Bond investors may want to consider the emerging markets for potential:  

  • Higher real yields
  • Diversification away from the U.S. interest rate cycle
  • Currency diversification as the U.S. dollar experiences continued pressure

Investors may also view emerging markets as less of the commodity play of yore and instead as a potential growth engine for their portfolios. This segment provides access to companies on the cutting edge of new technologies, life sciences, education, and many other areas.  

The last time emerging market equities traded this cheap relative to the developed world, they went on to outperform the S&P 500 Index significantly from 2001-2010.3

If emerging markets are missing from your portfolio, consider talking to your financial advisor about investing opportunities. Since this market tends to be one of the more volatile asset classes, be sure to take into account your risk tolerance level and the investment time horizon for your goals.

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