It is one of the key tenets in investment.
If you take on more risk, you expect more reward.
It underlies why we invest in start-up businesses, new technologies, illiquid assets and much, much more. And it explains why individuals and institutions have ploughed vast sums into Emerging Markets.
Emerging Markets, now taken as a given asset class, really came to the fore in the 1980’s as investors looked to enhance what they assumed would be moderate returns from developed markets. An Emerging Market (EM) was usually smaller with lower per capita income, had some characteristics of a developed market, but did not fully meet its standards in terms of liquidity, transparency, regulation etc. Think Indonesia, Ecuador and others.
The asset class exploded in terms of investor interest and assets invested. The main components within EM were Asia, Latin and South America, and Central and Eastern Europe.
So has EM delivered for investors in the past 15 years or so?
In terms of risk, the answer is yes. The standard deviation of returns has been higher in EM than Developed Markets. For Latin America, risk levels have been almost double. Drawdowns in EM have also been more severe.
It’s a different picture when it comes to investment returns. In the past 15 years, EM equities as measured by MSCI have delivered cumulative returns of about 130%. Developed markets for the same period are up 220%! There have been blowout years such as 2009 when EM stocks rose 80% compared to mainstream returns of 30%, but these were often catch-up years. Over the longer period EM has failed to deliver.
We have also seen performance diverge within the EM universe. We have for example seen Latin American stocks in negative territory when the overall EM outcome was positive.
So how does EM stack up today?
In the past 5 years, EM trailed Developed Markets by about 5% per year in investment returns. This is probably not surprising – EM economies had a tough Covid. Delayed vaccination and less fiscal ability to support the economy meant low growth and weakened government finances. It also means any rebound will be constrained. Within EM, Latin America endured an especially high level of suffering. Brazil, for example, experienced 34 million cases and nearly 700,000 deaths. This poor social and economic picture is reflected in financial market outcomes. In 2020 when EM overall posted a positive return of close to 20%, Latin America was down by nearly 15%. This divergence in performance continued into 2021.
But in 2022, we have seen a closing of this gap. EM markets are off 17%, In common with global equities.
But Latin American stocks are up by 7%.
This difference has nothing to do with business models, corporate strategies, or any other micro issues. The gap is due to two global trends – surges in oil prices and other commodities notably copper. Chile is up close to 30% reflecting the improved price environment for copper – its signature export. Other countries such as Brazil are effectively petro-economies and record energy prices have boosted government finances.
This matters as investors need to be clear on market drivers, their sustainability and likely direction.
And it is important that such drivers, no matter how powerful don’t distract from what may be less positive undertows. Politics may well play a role in many Latam countries over the next 6 months. Argentina has a 100% inflation rate, a divided government and a recent assassination attempt on the vice president. Chile has a left leaning government which recently had its proposed new constitution voted down by the people. Brazil is facing into October elections, where a victory (claimed or otherwise) by Bolsonaro, a politician who makes Trump look like a beacon of integrity and gravitas, cannot be ruled out.
Investors need to take such issues on board, together with the issues of interest rates and inflation which EM is facing into in common with global markets.
How should investors look at EM now?
c The premise that higher returns will accompany higher risk has not be borne out
c EM is not a homogenous asset class but can display a wide range of returns.
c EM are still tightly linked into global, macro trends.
There is no shortcut. The golden age for EM started with absurdly low valuations.
Today this may apply to selected stocks – but not in aggregate.
Tradewinds 