Emerging markets are predictably unpredictable

November 19, 2015 Categories: Portfolio Corner
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Emerging market equities, as measured by the MSCI Emerging Markets Index, have had a rough time this year. Year to date, as of October 30, the asset class is down -9.4%. In the third quarter alone, it was down -17.9% as of September 30. Much of these returns can be attributed to China. But even without the shorter-term “China factor,” emerging market equity investments are inherently less predictable than developed market holdings.

The silver lining is that emerging markets have historically bounced back from similarly disappointing performance in the past. Sharing some of the following facts with your clients may help them stick with their emerging market position – which still has an important role to play within an outcome-oriented multi-asset portfolio.

The China factor

Today, emerging markets make up 41% of global GDP1 and China makes up 18% of the MSCI Emerging Markets Index. Therefore when looking under the hood of the MSCI Emerging Markets Index performance, we cannot ignore China. On the face of it, the country’s negative return of -11.39% year to date as of 9/30, and third quarter return of -22.71% isn’t pretty. China’s economic and market struggles have made headlines over the last 12 months largely due to the noise generated by the A shares market, generally only available to local Chinese investors, and the devaluation of their currency last August. In response, Chinese fiscal policy appears to be accommodating the financial markets with targeted stimulus programs and the announcement of new rail projects, both intended to support the economy.

While Russell Investments isn’t particularly bullish on China in the short-term, the longer-term case is more compelling – particularly for investors in diversified portfolios. After all, China

  • is the most populous country in the world,
  • has the second largest economy in the world,
  • has a fast-growing population, and
  • is prominent in its region.

These factors suggest that China will outgrow its current rank as “only 1/16th size of the U.S. stock market” and for global investors, China will likely become increasingly important.

Sources: World Bank, IMF, and MSCI Indexes. All data as of 9/30/2015.

Sources: World Bank, IMF, and MSCI Indexes. All data as of 9/30/2015.

The volatility factor

The “China factor” aside, emerging market equities have always been “predictably unpredictable.” They have experienced some memorable pullbacks – and also impressive rebounds. Take the last 27 years as an example. The following chart shows that, on average, the asset class has managed to deliver attractive returns down more than 20% in a 12-month period:

  • The following 12 months saw an average return of 34.6%.
  • The following 3 years saw an average annualized return of 16.1%.
  • The following 5 years saw an average annualized return of 22.7%.

Of course these are averages. The chart also shows the best/worst periods with quite a barbell on the extremes. Again, emerging markets are predictably unpredictable.

Of course, it’s anybody’s best guess whether the latest period of -20.0% returns over a 12-month period will be followed by a spectacular return in the 90% range (note, that’s not what we are currently predicting at Russell Investments), but it has happened before.

Source: Emerging Markets – MSCI Emerging Market Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Source: Emerging Markets – MSCI Emerging Market Index. Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Growth potential

So, why might investors consider holding onto their emerging market equity position? Relative valuations are becoming more attractive. And, GDP growth looks compelling on a relative basis, too.

For the last 15 years, emerging markets GDP growth as reported by the IMF has been consistently higher than that of the rest of the world. Looking ahead, the IMF is forecasting GDP growth for the region to be over 5% by 2020. This is compared to 1.9% for developed markets and 4% for the rest of the world.

 Source: International Monetary Fund

Source: International Monetary Fund2

The bottom line

Emerging markets are risky and have historically been more volatile than developed markets. That said, emerging markets have the potential to be rewarding as part of an actively-managed, multi-asset portfolio for investors with appropriate risk tolerance.

1 Source: International Monetary Fund: Report for Selected Country Groups and Subjects.

2 Source: IMF Data Mapper: World Economic Outlook (October 2015)

MSCI Emerging Markets Index: A float-adjusted market capitalization index that consists of indices in 21 emerging economies: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

Forecasting is inherently uncertain and may be incorrect. It is not representative of a projection of the stock market, or of any specific investment.

Investments in emerging or developing markets involve exposure to economic structures that are generally less diverse and mature, and to political systems which can be expected to have less stability than those of more developed countries. Securities may be less liquid and more volatile than US and longer-established non-US markets.

Nothing contained in this material is intended to constitute legal, tax, securities or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type.

Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment.

Russell Investments is the owner of the trademarks, service marks and copyrights related to its indexes.

Russell Investments is a trade name and registered trademark of Frank Russell Company, a Washington USA corporation, which operates through subsidiaries worldwide and is a subsidiary of London Stock Exchange Group.

Copyright © Russell Investments 2015. All rights reserved.

This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. It is delivered on an “as is” basis without warranty.

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