Negative sentiments about emerging markets investments being put forward by market pundits share some common flaws. As political relations between Russia and the West become increasingly strained, pundits may see yet another reason to dial back on emerging markets investments.
The amount of short-term perspective is surprising. This shortsightedness and the anxiety caused by the most common criticisms being leveled at emerging markets deserve to be addressed. Equally, long-term investors should bear in mind the sound, and unchanged, strategic arguments for investing in the emerging markets equity asset class.
Missing The Forest For The Trees?
Volatility is one of the quintessential properties of emerging market equities. While the annualized return for the emerging markets class (as measured by the MSCI EM Index) over the last 10 years is 11.2 percent, it has been marked by high volatility. Looking at the top 10 major equity asset classes for the last 10 years, we see that emerging markets equities were the top-performing class in six of those 10 years and at the bottom of the list three times. With such volatility come large shifts in sentiment, with the general opinion regarding the asset class going from extreme pessimism to extreme optimism.
Reviewing many of the recent articles and opinion pieces, it is clear that we are currently entering a period of extreme pessimism. And while there has been some focus on the newly named “Fragile Five” (Brazil, Indonesia, Turkey, South Africa and India), the current crop of emerging markets doomsayers have echoed a similar refrain: that the emerging market asset class, as a whole, is threatened by a combination of slower economic growth, currency weakness, inflationary pressures, current account deficits and central bank reactions. In addition, political risk is increasingly being raised as a concern with the number of upcoming elections in prominent emerging market countries.
A key consideration missing from most of these “duck and cover” discussions is the simple fact that many of these negative “new dynamics” of emerging markets investing are not new at all. The same factors were just as prevalent, if not more so, when commentators argued in favor of the class. Political risk is always present in the emerging markets, and to say now is an especially risky time means disregarding history.
Similarly, comparisons are being made to earlier emerging market crises (the Asian crisis of 1997-1998, etc.), comparisons that are problematic at best, given the advances made in the emerging market economies since that time. Historically, emerging market economic crises have been fed by a dollar-based currency peg or an abundance of dollar-denominated debt in the emerging economies. Over the past decade, many of the emerging economies prudently curtailed this risk to their countries’ balance sheets by either de-pegging their currencies or by issuing the bulk of their debt in their local currencies. In this context, any historical comparison to prior emerging market crises mismatches the mistakes of the past with the relatively more balanced conditions that currently exist.
The Long Game
None of this discussion negates the fact that the emerging markets are risky—emerging markets investing will always involve a degree of uncertainty and volatility. This has not changed during the past 20 years, and we do not predict that it will change anytime soon. While these risks are currently being viewed negatively, we believe these periodic bouts of pessimism are little more than a distraction from the strategic reasons for investing in the emerging markets asset class.
The risk of volatile situations emanating from the developing parts of the world is no greater now than in past years, but the long-term trends that drive long-term asset allocations remain intact. In times like these, emerging market investors may seek comfort in reviewing these facts about emerging markets, rather than being distracted by short-term pessimism:
• EM countries represent 50 percent of global GDP.
• EM countries drive two-thirds of the annual global GDP growth rate.
• EM countries represent 11 percent of the MSCI ACWI index, up from 4 percent just 10 years ago.
• EM countries represent 85 percent of the world’s population--with the potential for growth of a middle class consumer.
Sources: MSCI, IMF As of 12/31/2013
Short-Term Uncertainty vs. Long-Term Perspective
While emerging market equities may continue to demonstrate high volatility, and we do not dispute the reality of the dynamics that lead to short-term uncertainty, we find it misguided to be so broadly (and suddenly) pessimistic. The upcoming year may prove to be a challenging one for emerging markets, but one full of potential opportunities for those investors who do not allow short-term dynamics to overshadow long-term perspectives.
So how do we react to so much short-term uncertainty? We do not. Our experience shows that managing risk by broadly diversifying holdings, avoiding concentrations and rebalancing portfolios is key to maintaining long-term exposure to the asset class through the high and low tides of investor sentiment.
Timothy Atwill, Ph.D., CFA, is managing director, investment strategy, at Parametric Portfolio Associates, a Seattle-based asset management firm. Parametric manages approximately $20 billion in its emerging market strategy.