The 2-Minute Thought: Sticking with Emerging Markets

If you own emerging market stocks, you know it’s been painful this year. The chart below from McKinsey shows just how wide the divergence has been between emerging markets and the stellar S&P 500.

 Source: McKinsey Global Institute

Source: McKinsey Global Institute

To say that emerging markets are out of favor now is a bit like saying water seems a bit wet. But when bad things happen, we always like asking if things are permanent or temporary – and taking a longer-term perspective.

On the long term, it’s worth remembering that emerging economies have accounted for almost two thirds of the world’s GDP growth the past 15 years – that’s according to McKinsey. Performance has been highly variable among countries, as emerging economies aren’t a single monolith. But McKinsey found 18 outperformers out of the 71 countries they examined over the last 50 years -- so let’s not throw out the baby with the bathwater.

McKinsey found seven countries that achieved real annual per capita GDP of 3.5% over the last 50 years – the threshold required to take low-income and lower middle-income economies to upper middle income status over a 50- year period. These countries were China, Hong Kong, Indonesia, Malaysia, Singapore, South Korea, and Thailand.

In addition, McKinsey found another 11 countries that achieved real average annual per capita GDP growth of at least 5% over the 20 years during 1995–2016. These 11 were Azerbaijan, Belarus, Cambodia, Ethiopia, India, Kazakhstan, Laos, Myanmar, Turkmenistan, Uzbekistan, and Vietnam. Together, the 18 outperformers McKinsey identified have been responsible for lifting a billion people out of extreme poverty.

That is the macroeconomic side. On the business side, from 1995 to 2016, the revenue of large emerging market companies relative to their country’s respective GDP almost tripled in the 18 outperforming countries.

And the companies that survived a cutthroat domestic environment became “hardened and formidable competitors on the global stage.” As a result, between 1995 and 2016, large public listed companies in the outperforming emerging nations produced total returns of 23% on average, versus 15% in mature economies.

In his latest quarterly letter, Ben Inker of money manager GMO acknowledged that emerging markets have been lousy. He also acknowledged that emerging market assets follow momentum – so there could be more pain to come.

But Inker’s conclusion is that in spite of their poor performance, little has changed in the fundamentals of emerging market stocks. The stocks largely got battered because emerging market currencies got battered. That is par for the course in those economies – emerging stocks and currencies are highly correlated. The other thing is that the words “trade war” generally don’t bode well for emerging markets. But then again, those words don’t bode well for anyone else either.

Emerging market stocks are volatile. They are risky – perhaps one of the riskiest asset classes there is. But temporary should be distinguished from long-term. And after reassessing the group, Inker reaffirmed: “Emerging market value stocks are the best asset class we can find, by a margin that is just off of the largest we have ever seen.”

Famed emerging market investor Mark Mobius also says emerging markets are full of opportunity. Perhaps you don’t jump in with both feet, he says, but you stock-pick. Individual companies are where you’ve got to focus.