When considering the inclusion of an asset class in an investment portfolio, two factors need to be considered: risk and return. For years, many investors looked at emerging markets as providing far too much risk to even consider the return. And while most are aware that emerging markets are growing, few realize just how large they have already become.
It pays to remember that, within a global stock portfolio, the diversification benefits of adding emerging markets could actually reduce overall risk. More importantly, I’d argue that it will improve returns in the years ahead: Valuations are considerably lower than they are in developed markets and, combined with higher economic growth rates, emerging markets are very likely to outperform over the next decade.
According to the World Bank, by 2050 both China and India will have GDPs exceeding that of the United States. The World Bank reduced its growth forecasts for the global economy in its January report summarized in the table below. But it noted increasingly divergent trends.
The Bank remains pessimistic about the prospects for the developed world but more optimistic about the emerging economies. While growth has slowed in the developing world, the growth prospects for emerging-market economies remain substantially higher than those for the more mature economies. A major reason for the divergence is the substantial differences in demographics.
Populations are aging rapidly throughout the developed world. The ratio of the working-age to non-working-age population will fall sharply over the next decade, as is shown in following table. By the end of this century, Japan will have more non-workers than workers. On the other hand, populations in India and Brazil will be getting younger. Even in China, with its one-child policy, the demography will remain far more favorable than it is in more developed economies for at least the next decade. (It’s far too early to say whether China’s new “two-child” policy will have an effect on its population growth.)
Countries with younger populations tend to grow faster.
Despite such high growth potential, investing in emerging-market equities does involve additional risk. These equity markets are extremely volatile, and some nations have relatively unstable governments. There are also currency risks to consider (or the need to engage in potentially expensive currency hedging). Risk mitigation would indicate a smaller share of one’s investment portfolio should be devoted to emerging markets than one might suggest.
But these factors alone should not deter investors, even those with an affinity for conservative investments. Portfolio considerations can cut the other way, particularly when assessing an entire investment portfolio. As long as the correlations with EM equities are moderate, adding volatile EM equities to a globally diversified portfolio can actually decrease portfolio risk.
Return considerations, on the other hand, would justify a significant share of an investment portfolio devoted to emerging markets. The U.S. equity markets have rallied sharply since the depth of the financial crisis in 2008, and present valuation levels suggest that future returns will be far more modest. Emerging markets, conversely, have demonstrated high levels of growth potential, fueling gains that will likely outpace the U.S. equity markets.
One of the best predictors of long-run equity returns is the so-called CAPE ratio — the current price of the broad U.S. stock-market index divided by the average earnings of the component companies over the past 10 years (this is also known as the Shiller P/E Ratio). This “cyclically adjusted P/E ratio” is not a reliable predictor of returns one or two years into the future, but it does provide a useful (though not perfect) forecast of returns 10 years in the future.
The chart below presents U.S. data starting in 1926. When stocks had CAPEs of 10.5 or lower, the U.S. market produced 10-year returns of over 16%. But when CAPEs were 25 or higher, returns tended to be far more modest, averaging under 4%.
Unfortunately, the CAPE ratio in the U.S. markets today is over 27 — an unusually high reading. Only in 1929, before the stock market crash and the Great Depression, and in early 2000, at the height of the Internet bubble, was the CAPE at higher levels. To be sure, interest rates today are unusually low, and that provides a justification of high asset prices. But they have been low in the past, and the data still suggest that we should be projecting only modest future equity returns.
The CAPE is a useful indicator for future stock-market returns not only in the United States but also in foreign and emerging markets in general. The correlation of the CAPE with future stock market returns is low for short investment horizons but rises to 0.6 over 10 or more years in the U.S. The following chart presents some recent data for the CAPE in emerging markets.
Unlike the situation in the U.S., emerging markets have been relatively unpopular, and valuations are extremely modest.
The table at lef shows that EM CAPEs are currently less than 15. They have been far higher in the past. At today’s levels, they suggest relatively attractive returns over the longer run. The relative valuations in world financial markets suggest that a substantial allocation to emerging-market equities can be justified, despite their greater risk.
To reasonably assess the appropriate exposure of an investment portfolio to emerging markets, it is important to understand their size and importance to the world economy.
The table below presents total market capitalization of the various regions of the world. Note that the United States represents only 36.2% of the world’s market capitalization. Emerging markets represent 24.6%.
Thus, if an investor wishes to hold a global portfolio weighted by market capitalization, almost one-quarter of that portfolio would consist of emerging market equities.
Another metric that might be used to judge the appropriateness of an emerging markets equity allocation is to examine their share of world GDP. Intercountry comparisons can be tricky, requiring exchange rates and purchasing power parity adjustments. In one estimate made by the International Monetary Fund, emerging markets have already exceeded the GDP of the developed market countries as is shown below.
Emerging markets today present an opportunity for investors to both mitigate risk and increase reward. Navigating these markets within the complexities of a global marketplace requires analysis not just as a standalone asset, but for the role it plays within an entire portfolio. Investors of all walks, conservative to those more risk-adverse, can find attractive options in the emerging markets sector. Once deemed too risky, emerging markets now present a hidden gem that is too risky to avoid.