A Global Risk Reward Perspective

October 27, 2016

A Global Risk Reward Perspective

  • Emerging markets will grow faster than advanced economies, but there are many investing risks.
  • If a currency is at risk of being devalued 50% against the US dollar, over a decade you’d need an additional 7% yearly return to cover for it.
  • It is less risky to invest in emerging markets when there is pessimism than when there is euphoria.

Introduction

The World Bank revised its 2016 global economic growth forecast down to 2.4 percent from the 2.9 percent pace projected in January. The main reason for this downward revision came from lower commodity prices globally and soft investments in developed countries. But what’s important here is the divergence between the growth in emerging versus developed economies.

Advanced economies are expected to grow 1.7% in 2016, while emerging economies will grow 3.5%. In 2017 and 2018, as commodity prices are expected to rebound from the 2016 lows, emerging markets will reach growth of 4.4% and 4.7%, respectively, while advanced economies will grow only 1.9% in both years.

figure-1-global-economic-growth
Figure 1: Global economic growth. Source: World Bank.

Growth differences of almost 300 basis points are very significant for an investment portfolio. Lets have a look at individual countries where investments can be made and assess the risks of investing in them.

GDP Growth By Individual Country

The leader among advanced economies is the U.S. with expected growth of 1.9% for 2016, while the laggard is Japan with a meagre growth rate of 0.5%. The leaders among emerging countries are China with 6.3%, Indonesia with 5.1%, Poland with 3.7%, and India with 7.6%, while the laggards are Brazil with -4% and Russia with -1.2%.

figure-2-growth-by-country
Figure 2: Real GDP growth and estimated growth. Source: World Bank.

From an economic perspective, India is the clear leader, followed by China and Indonesia. But before rushing into these emerging markets, we have to analyze the risks.

Economic Risks Related To Growth

The biggest investment risk for international diversification comes from inflation and currency depreciation. The current inflation rates are 4.31% in India, 1.9% in China, 3.07% in Indonesia, 8.48% in Brazil, and 6.4% in Russia.

Alongside inflation, the Indian currency has lost 40% of its value to the U.S. dollar in the last 10 years, the Chinese currency has gained 15%, the Indonesian currency has lost 30%, the Brazilian currency has lost 35%, and the Russian ruble lost 58%. In order to cover these currency risks, we have to invest in emerging markets at a higher premium. If there is a risk that a currency loses 50% of its value in the next decade against the dollar, you need an additional return of 7% per year to compensate for that loss. Of course, it’s possible that emerging currencies strengthen, which is then a positive. But given the volatility in emerging markets, it’s wise to buy when assets are really cheap and fundamental returns are high. This usually happens in difficult economic and political times, but we can be almost certain that emerging markets are going to grow in the long term. Therefore, we should forget about short term market movements when investing in emerging markets and look at the long-term picture painted by GDP growth, demographics and investment returns.

A good example that shows why it’s best to wait for the bad times before investing in emerging markets is through a comparison between the volatility of the iShares Emerging Markets ETF (NYSEArca: EEM) and the iShares S&P 500 ETF (NYSEArca: IVV).

figure-3-markets
Figure 3: Emerging Markets ETF (top) and the S&P 500 ETF (bottom). Source: iShares Emerging Markets ETF, iShares Core S&P 500 ETF.

Emerging markets fell 60% from their prior peak during the Great Recession, during the economic troubles in Europe in 2011—due to the uncertainties related to Greece—emerging markets fell 30%, and last year when there were fears about China slowing down, emerging markets fell 35%. Meanwhile, the S&P only fell into one bear market, the Great Recession.

As emerging markets are vast, any kind of trouble in Japan, Europe or the U.S. immediately impacts them as investors consider emerging markets risky due to their volatility, and thus pull their funds out at the first sign of trouble. But, the underlying fundamentals, demographics and economic growth makes emerging markets a much better certainty than developed economies sustained only by quantitative easing and low interest rates.

From a PE perspective, the iShares MSCI Emerging Markets ETF has an average PE ratio of 11.62 (this is a skewed metric because it does not take negative EPS into account, but it’s still good for comparison with the S&P 500), and the S&P 500 ETF has an average PE ratio of 19.75 (this also doesn’t include negative PE ratios).

Conclusion: Rebalancing Your Portfolio Between Emerging & Developed Markets

On the one hand, we have better economic growth prospects, better demographics, and cheaper stocks with emerging markets, while on the other we have aging populations, slow economic growth, and expensive stocks in developed markets.

From a long-term perspective, the picture is very clear: emerging markets will be the drivers of global growth and returns to your portfolio. But from a shorter-term perspective, emerging markets have more short term risks, from currency swings to volatility from panic selling. As such, the best thing to do is to rebalance your portfolio weights.

When emerging markets are hot, lower your exposure, and when other investors are running away—as they did in January 2016,—increase your ownership. To execute such a strategy, you have to be willing to accept potential short term declines, and be ready to buy more when they occur. In the long term, you’ll be more exposed to the inevitable growth emerging markets offer.