The Strategic Case Against Emerging Markets

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It hasn’t been much of a year since people thought of different ways to extend portfolio exposure across risky asset classes. Inflation, geopolitical tensions, dysfunctional supply chains and all the other wet weekly topics left portfolio managers’ focus on deficit protection. But in this business, it is always wise to look ahead, because what goes down sooner or later will come back up again. In that spirit, this week we’re turning the spotlight on the emerging market equities asset class.

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A Bit of a Misnomer

Let’s start with the simple truth of what you’re actually getting when you invest in a broad-based emerging markets index. MSCI has been in this game longer than anyone, and their index of emerging markets is often the gold standard of the asset class. What’s in that index? According to the most recent spelling through October 2022, exactly 69 percent comes from four Asian countries: China, India, Taiwan and South Korea. The rest, the world of emerging markets from Latin America to Eastern Europe, the Middle East, Africa and the rest of Asia, is in the remaining 31 percent. Considering the strategic fundamentals, the MSCI EM index is essentially a bet on the future prospects of the largest economies in Asia (except, of course, Japan, which graduated from “emerging” status many decades ago, and the financial centers of Singapore and Hong Kong).

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Thirty years is a long time

So how have things fared for this asset class so far? Consider the thirty-year performance of the MSCI EM index versus the S&P 500. Thirty years is a long time and there are many market cycles – and remember that the whole premise of a risky asset class like emerging markets is that by taking on that high level of market risk, the investor should expect longer-term returns.

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S&P 500 vs. MSCI emerging markets track performance over 30 years

The message above this chart is simple: over the past thirty years, from 1992 to today, the S&P 500 has returned more than three times the emerging markets index for a US investor (returns are here. in dollars, home currency of a domestic investor is expressed). The bottom line message is that all those diminishing returns come with more risk. Consider the Asian currency crisis of 1997 (shown on the map). The EM index fell and then rose again in late 1998 – but even after the rebound, the index was below its pre-crisis level. All the while the S&P 500 was steadily advancing during the economic boom of the late 1990s.

In the chart you can also clearly see that there are select periods of strong performance by emerging markets, and none more so than the China supercycle period of the early 2000s (also noted). It was during this period that China surged on its way to becoming the second largest economy in the world. Even after the global financial crisis of 2008, China, along with other Asian economies, recovered faster than other parts of the world. But the supercycle finally fizzled out in the 2010s when China tried — repeatedly and mostly without much success — to rebalance its economy away from massive state spending into infrastructure and property development and consumer spending.

Tactical investing works if you get the timing right, but in our opinion, executing it is more a matter of luck than a matter of skill. And you need Lady Luck’s favor twice—not only to know when to get in but, perhaps even more difficult, when to tell her to quit and get out.

The Almighty Dollar

Another important indicator, one that is true for any investment outside of the home currency, is the strength of the dollar. An important part of the performance of domestic stocks over both new and developed non-US markets, especially over the past decade, has been the continued dominance of the dollar during this period. If you invest in a foreign asset and that asset earns a ten percent return but the currency the asset is in depreciates ten percent against the dollar, then your portfolio statement at the end of that period will show a zero return. Even with historic interest rates prevailing until the end of 2021, the dollar has maintained its strength and made it clear that, for now anyway, there is no viable challenge to its status as the world’s reserve currency. And it is important when it comes to portfolio choices.

So what about development? The world economy seems to be in a different place today than it was during most of this 30-year period, with more hostility and less than the unbridled cooperation that characterized the peak era of globalization. China, for one, is investing heavily in targeted sectors where it hopes to achieve dominance, including clean energy technologies and biosciences. India has seen some solid growth in recent years. Taiwan continues to dominate the global semiconductor industry through Taiwan Semiconductor Manufacturing (TSM), which makes 80 percent of the world’s advanced chips (South Korea’s Samsung (OTCPK: SSNLF ) is the other gorilla in this sector). .

One of our main tenets as portfolio managers is that we don’t adhere strictly to ideology. We will never invest or invest because of a preconceived belief system. What we will do is evaluate the data and evaluate the pros and cons of alternative strategic choices. For now, when looking ahead to where we might place more emphasis on riskier asset classes, we tend to look elsewhere than emerging markets. That may change – but for now, we think the negatives outweigh the pros.

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Editor’s Note: The short shots for this article were selected by the editors of Seeking Alpha.


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