The relatively poor returns and higher volatility that has come with emerging markets in recent years should not put investors off maintaining long-term exposures to the asset class, according to JP Morgan Asset Management’s Karen Ward.
Over the past five years, the MSCI Emerging Markets index has posted a 55.42 per cent total return (in sterling terms) and underperformed the MSCI World, which is made up of developed market stocks, by around 25 percentage points.
What’s more, emerging markets have given investors a much rougher ride. FE Analytics shows that MSCI Emerging Markets’ annualised volatility stands at 14.33 per cent while its maximum drawdown was 22.12 per cent; in contrast, the volatility of the MSCI World was 9.88 per cent with an 11.35 per cent maximum drawdown.
Performance of indices over 5yrs
Source: FE Analytics
While the developed market index has been powered ahead by US equities, which have led the rally for most of the post-financial crisis period, emerging markets have been hamstrung by a number of factors including the strong US dollar, fears of a ‘hard landing’ in China, the end of the commodities supercycle and, more recently, the US-China trade war.
But Karen Ward, chief market strategist for EMEA at JP Morgan Asset Management, said: “Emerging market stocks have had a rollercoaster ride in recent years. This is not unusual for an inherently volatile section of the global stock market. However, investors with longer time horizons shouldn’t be deterred.
“As the economic engine shifts increasingly east and south, and capital markets develop in tandem, emerging markets would be expected to offer returns in excess of the developed world.”
Ward added that factors such as slowing population growth and declining productivity in the West might make it look as though the outlook for global economic growth and therefore market returns is “bleak”.
However, she argued that a closer look at the changes in emerging economies suggest the global economy is not completely tied to the fortunes of the developed; rather, she noted that emerging economies are “doing a lot of the heavy lifting in delivering global growth these days”.
Contribution to annual global real GDP growth
Source: Refinitiv Datastream, World Bank, JP Morgan Asset Management. Data as of 28 Feb 2019
“The stronger growth from emerging markets is not because populations are growing much more rapidly elsewhere. Parts of Asia face similar demographic challenges to countries in the developed world,” Ward said.
“Instead, they are growing because they are increasingly embracing the technologies of developed nations and, as a result, are experiencing a process of economic catch up to the levels of income experienced in the more advanced economies.”
The strategist also argued the examining data on income per capita and the proportion of the population living in urban rather than rural areas offers an encouraging picture. According to these metrics, China and India – two of the most populous nations on the planet – are still at a very low stage of development and have much further to grow as they catch up to the West.
Of course, not every low-income country will catch up with the developed world to an equal extent. Ward pointed out that parts of Africa have not progressed beyond very low incomes while many parts of Latin America seem stuck in a middle-income trap.
The reasons for this can be short-term policy deficiencies – a common example being over-borrowing by governments in international capital markets leading to capital outflows, currency depreciations and economic contractions – or deeper long-term structural factors, such as whether legal and property rights spur investment or if education systems are sufficient for workers to adapt to new technologies.
“When policymakers do manage to provide the right structural foundations the process of catch-up can be swift. This was perhaps best seen in Japan through the 1960s and 1970s,” Ward said.
Overall, JP Morgan Asset Management sees “ample room” for the emerging markets to continue catching up with the developed world and therefore play a greater role in global growth.
But while in the past investors preferred to take exposure to emerging markets through developed world stocks with greater revenues from those countries, Ward suggests that this is now changing.
A current example is plans by index provider MSCI to include more Chinese A Shares in its flagship emerging markets index, increasing the opportunity set for those investors wanting more direct exposure.
Weight of China in emerging markets
Source: MSCI, World Bank, JP Morgan Asset Management. *Share of EM GDP is for 2017 and is calculated as Chinese nominal GDP in USD as a percentage of all emerging markets in the MSCI EM index. 100 per cent A Share inclusion is shown for illustrative purposes only. Data as of 28 Feb 2019
“Emerging market stocks will likely remain a more volatile section of the global stock market. Those that have a strong preference for assets whose prices slowly and steadily grind higher may not appreciate the additional volatility that emerging markets bring to a portfolio,” the strategist said.
“If, however, investors have a long time horizon and can stomach the volatility, then emerging markets would be expected to pay returns well in excess of developed market equities in the coming decades.”
According to JP Morgan’s 2019 Long-Term Capital Market Assumptions report, total annual returns in emerging market equities are expected to be close to 8 per cent on average over the coming decade – compared with just 5 per cent for developed market equities.
“For those able to lock up funds and stomach the potential volatility, emerging market stocks – and Asian stocks in particular – may well make a strong addition to a portfolio, particularly given current valuations,” Ward concluded.