Emerging markets often make the news for the wrong reasons. Political instability, trade uncertainty and external debt vulnerabilities can have a negative impact on the perceptions of all emerging markets – even when problems are country-specific. Our view is that investors would be better served by ignoring the ‘emerging market’ label and making judgments on a country-by-country and even company-by-company basis.
There are many myths around emerging markets. Consider two:
Myth 1: "Emerging markets have higher growth rates"
The term 'emerging' suggests premium levels of growth compared to developed markets. It is true that since the 1990s emerging markets as a whole have grown faster compared to developed economies. But digging deeper shows that their collective success was mainly caused by the high growth levels of a limited number of Asian countries, particularly China, Taiwan and South Korea.
Many other emerging economies have actually had lower growth rates than the US, the world's largest developed economy. For instance, in 1980 South Africa's GDP per capita was 37% of the per capita GDP in the US. It is now just 23%. As chart 1 illustrates, the same is true of Mexico, Brazil and Argentina, all of which have seen falls in their relative per-capita GDP compared to the US.
Chart 1: Per-capita GDP of emerging markets relative to the US. Source: IMF. Per-capita GDP relative to the US on a purchasing power parity basis. From 31 December 1980 to 31 December 2017.
The divergence in economic growth levels between individual emerging markets is significant. South Korea and China both managed to grow their economies by almost 6% per annum, while Argentina and South Africa grew by just 1% per annum. These differences reflect economic policies in Asia which supported the accumulation of physical and human capital, resulting in rapid growth rates.
For investors, assuming that countries will grow rapidly simply because they are classified as emerging markets is a mistake.
Myth 2: "Economic growth translates into higher investment returns"
It is often assumed that the higher growth and higher risk of emerging markets will translate to better investment returns. In reality, there hasn't been any significant outperformance of emerging market equities. A recent long-term study showed that emerging markets have actually underperformed developed markets between 1900 and 2017. Even over shorter periods, there is no significant outperformance of emerging market, if anything the returns are lower.
There is also no significant long-term relationship between the level of GDP growth and equity market returns. For instance, the US equity market has had one of the highest returns in the past decade, despite other countries having much higher GDP growth rates.
In our view it is more important to analyze business models, corporate governance, political stability and innovation than to assume higher GDP growth will automatically translate into higher returns.
So are there any opportunities in emerging markets?
Yes, it's not all doom and gloom. Emerging markets will continue to provide active investors with opportunities.
History has shown that markets tend to overreact based on standard investment rules. For example, economic tightening by the US Federal Reserve is associated with negative returns on emerging market assets. These rules have some validity, as many countries are dependent on foreign financing, so rising short-term interest rates can be negative. However, other countries which are not as dependent on foreign financing still tend to experience sell-offs when US short-term interest rates rise. This happened at the start of 2016 and is happening again now. This provides opportunities for active investors who are able to identify over-sold markets.
Emerging markets also offer access to world-class companies with shareholder-friendly policies operating in industries with high barriers to entry. Recent examples include a Taiwanese company which is one of the few global manufacturers of the world's most advanced computer chips. We also invest in a Chinese sportswear company with high operational gearing which is benefitting from the rapidly growing middle class in China.
So, for investors willing to look at emerging markets and companies on a case-by-case basis, there is no shortage of opportunities.