Let me just say it upfront: emerging markets (EM) can be unpredictable. This unpredictability can drive cautious investors away to the comfort of more familiar U.S. and developed country stocks and mutual funds, but doing so could cause them to miss out on long-term benefits and attractive returns for their portfolios.
Although there is no one definition of an emerging market, The Economist has a quick and easy one: an emerging market has an economy that is not too rich, not too poor, and is not closed to foreign investors. The largest emerging markets are China, Taiwan, South Korea, India, Brazil and Russia, but there are dozens more throughout Asia, South America, North America (Mexico), Africa and Europe. It does not include frontier markets that are even less developed or have restrictions on foreign investment.
Emerging markets do not move in lockstep with the U.S. and this non-correlation can be a benefit and a curse when justifying an allocation to EM. Non-correlated assets help bring down overall portfolio volatility, but they can also hold back returns when U.S. markets are surging ahead. That has been the case so far this year with the S&P 500 up close to 20%, well ahead of most international indexes.
Despite this recent U.S. outperformance, there are a number of reasons why EM is attractive in the near term:
- The U.S. economy has rebounded strongly from the Covid shutdown of 2020. The stock market has fully recovered and the major indexes have surged to record highs. Many emerging economies have not yet bounced back as much as the U.S. and their stock markets have not fully recovered. The best time to invest is before markets have recovered so there is some opportunity for EM to outperform from here.
- After a year or two of elevated growth, the U.S. is expected to shift down to lower growth rates, while EM economies are expected to continue to grow strongly.
- The valuations of U.S. stocks are well above historical averages, while emerging market stocks are trading at lower relative valuations than they have in the past. EM corporate earnings are expected to grow faster than their U.S. counterparts, so the relative valuations look even more attractive going forward.
Longer term, there are several economic and demographic trends that favor emerging markets:
- The U.S. dollar is expected to weaken as the impact of the unprecedented fiscal stimulus begins to be felt. Foreign exchange rates are notoriously hard to predict short-term, but the large deficits the U.S. has run-up are expected to put pressure on the dollar over the longer-term. A cheaper U.S. dollar is good for emerging markets.
- Emerging markets have a fast-growing middle class that will have more money to spend on goods and services to stimulate their economies. Countries with huge populations such as China and India are expected to see a dramatic increase in their middle class as their growing economies lift people out of poverty. This should spur an increase in spending, leading to more economic gains.
- The U.S. and other developed markets have aging populations, which will result in a smaller workforce and slower GDP growth in the future. A perfect example of this is Japan, which has been plagued with a stagnating economy, an aging population and a shrinking workforce. At the opposite extreme, 90% of the world’s under-30 population live in emerging markets. This segment of the population accounts for over 75% of all online transactions and is contributing to economic growth.
This list does not guarantee that EM will outperform this year or even next. Investing in EM can be frustrating at times, but the outperformance of EM can be swift and dramatic when it does occur. Keeping a modest allocation in the asset class over the long-term will allow an investor to benefit from that outperformance without having to perform the impossible feat of market-timing a move into or out of unfamiliar markets. Many of our client portfolios include an allocation of a few percentage points.
EM is one of the asset classes where active management has performed better than investing in the index. Each country is at a different stage in its economic cycle, so actively choosing were to invest is important to overall performance. We use fund managers who have vast experience on the ground in these markets – visiting companies to learn first-hand where the opportunities are for attractive investment opportunities and employing local analysts to keep abreast of risks and opportunities.
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