10 Aug

The Case for Emerging Markets Equities

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While quite popular during the 1980-2000’s due to outsized relative returns, emerging market (“EM”) equities have recently suffered amidst much-publicized headwinds including geopolitical tensions in Russia, policy uncertainty in India, and a growing Chinese asset bubble.

Better-known developing economies such as Brazil, Russia, India, and China tend to dominate the

headlines; but, the term “emerging markets” actually refers to a much broader range of constituents. The MSCI Emerging Markets Index currently lists 21 countries with highly varied economic, demographic and cultural profiles, which represent an increasing proportion of the world economy. Despite the recent negative attention, EM securities remain compelling due to historically strong performance, attractive valuation levels, robust diversification benefits, and growth potential.

EM equities, when viewed as an asset class, may appear highly volatile over short time periods relative to more placid markets. Despite this greater level of risk, EM has outperformed both the U.S. and developed international equity markets over the longer term. While EM is susceptible to prolonged busts and high volatility, over the last 10 years average returns (14.0%) have outperformed the S&P 500 (7.3%). After a heavy downturn in 2008, flows into EM were particularly strong during 2009-2013, boosting performance and dampening volatility. Massive asset purchase programs from large, developed central banks pumped liquidity into the markets while driving interest rates to all-time lows, providing investors with both the means and motivation to search for yield in other markets. The current volatility in EM equities contrasts to the unusual period of calm in the markets brought on by quantitative easing. However, risk- adjusted returns should continue to compensate long term investors who are willing to accept the additional volatility during the transition to a more normal environment.

Many EM countries have undertaken vast structural improvements in recent years, attracting both international and domestic investors through stronger legal and capital-market frameworks. Of the total global market capitalization, the EM portion nearly tripled from the end of 2002 to mid-2013 while the U.S. and developed international markets percentage contracted over the same period. Ongoing economic development and reform programs are creating greater financial transparency in the shift to open market economies. Against a backdrop of rising rates in the U.S. and volatile currency exchange rates, several EM currencies have already staged large corrections, potentially limiting further downside. More proactive EM central banks have dramatically raised rates to curtail currency declines. The consensus outlook for rate of growth remains positive and is projected to continue, with potential shorter-term pullbacks along the way.

In terms of growth, World Bank consensus has predicted 90% of the world’s middle class will be in emerging markets in less than 20 years. The emergence of a genuine middle class in these regions can create a spending power shift from an export-oriented economy toward a domestic consumer-driven model. With a growing consumer base, spending in EM is on track to outpace the U.S., driving greater economic growth. Certain EM governments are also taking steps to boost trade within EM, creating flexible terms and currency settlements in an effort to mitigate foreign risk aversion.

In addition to growth potential, EM equities can provide diversification as suggested by lower correlations relative to broad U.S. equities and varying characteristics within specific countries, sectors and stocks. Lower correlations coupled with higher expected returns are supportive of a strategic allocation with EM equity exposure. However, due to the varied characteristics of EM countries and the fact that these stocks get far less analyst coverage than U.S. stocks, portfolio managers with specific skills in this asset class are best apt for exploiting the opportunities created by mispriced markets.

Despite recent headlines and extreme short-term market movements, the qualities present in EM equities remain attractive over longer periods. EM equities currently trade both below their long- term average and at a steep discount to U.S. price multiples. Some caution is warranted, as the recent inflows of liquidity that have buoyed this market could begin to recede. However, with its potential for growth, diversification benefits, and strong fundamentals, EM equities as an asset class remain an integral piece of a well-diversified portfolio for those whose risk tolerance and time horizon can tolerate greater short-term volatility.

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