![Emerging markets roller coaster: Riders wanted](https://www.benefitscanada.com/wp-content/uploads/sites/7/2012/05/emerging-markets-world-globe-economy-markets.jpg)
When it comes to investing, nothing spells roller-coaster ride quite like emerging markets. Data from MSCI show that in 2010, the MSCI Emerging Markets Index (in U.S. dollars) rose 19%. In 2011, it fell 18%. Last year, it rose 18%. This year, it’s down 11%.
Risk on, risk off. Risk on, risk off. What’s an investor to do?
If ever there was an equity allocation to take a long-term view of, it’s emerging markets (and their less-developed neighbours, the frontier markets). Investors who need access to their savings in the next couple of years—and have a weak stomach—may wish to steer clear. Perhaps this is self-evident, but nonetheless—Bloomberg data from 2002 through the middle of this year show that emerging markets equities have been more volatile than their U.S. and Canadian counterparts, as well as U.S. high-yield bonds.
For those with a little more stamina, emerging and frontier markets remain important contributors to a well-balanced portfolio. One of the most effective risk management strategies is the inclusion of low correlation assets, and emerging and frontier markets can serve that purpose when combined with other asset classes.
The overall bull case on emerging markets is familiar. The rise of the middle-class consumer in China, for example, is helping drive emerging markets’ contribution to global GDP. Stimulative fiscal policies are supporting infrastructure projects that should boost long-term productivity. When it comes to public debt, emerging market economies have much healthier balance sheets than most of their developed market peers. Large multinational corporations from the developed world continue to expand their reach in these countries.
What may not be so familiar is the drastic shift in the investment landscape as seen through the lens of credit quality. Data from JP Morgan Asset Management show that the market capitalization of debt classified as investment grade within the firm’s Emerging Markets Bond Index soared from near zero in 1993 to almost 60% by the end of 2011. That tells us there’s a significant kind of de-risking occurring among emerging market countries, in addition to the economic drivers outlined above.
It’s important to keep in mind, however, that there are vast differences among emerging market countries. The MSCI Emerging Markets Index captures the performance of equity markets in Brazil, China, India, Russia, Korea, the Philippines, Poland and Turkey, among others. A top-down approach is typically even more crucial for emerging markets—as opposed to pure bottom-up stock picking—than for developed markets. And political situations, inflation rates and interest rates are drastically different among those markets. Looking at the macro view is essential.
So what about timing? Emerging markets took a tumble in the first seven months this year, and there’s nothing to say the losses won’t continue—at least in the short term. But there’s a lot to say about the current long-term opportunity.
A standard valuation metric tells the story. Data from Bloomberg show that, as of late July, the forward P/E ratio of the MSCI Emerging Markets Index was at 10.4. For the S&P 500, that figure was 14.7. Put another way, emerging markets equities are roughly 40% “cheaper” than their U.S. counterparts. What’s more, the discount hasn’t been this large since October 2008—the month after Lehman Brothers collapsed and it seemed the financial crisis just getting under way would send the world into another Great Depression.
And while past performance is no guarantee of future returns, there’s no harm in taking a look at what happened with the MSCI Emerging Markets Index after October 2008. The one-year return in 2009 was almost 80%. Of course, there were many other factors at play at that time, such as the value of the Emerging Markets Index getting sheared in half during the 2008 meltdown.
But here we are today, examining the available evidence and scanning the global investment landscape for opportunities. Equity valuations suggest emerging markets offer a compelling one right now.
Sadiq S. Adatia is chief investment officer with Sun Life Global Investments. sadiq.adatia@sunlife.com. The views expressed are those of the author and not necessarily those of Benefits Canada.