2018_08_05 — “Inconceivable: Emerging market might not mean what you think it means”

August 5, 2018

Inconceivable*: Emerging market might not mean what you think it means

Traditionally, emerging market (EM) economies have been thought of as nascent, high growth, volatile economies that are generally smaller than developed market economies.** In the past, most EMs also fell under the derogatory terms of “Third World” or periphery countries. In recent years, although the business world recognizes China as a global economic force — as it vies with the U.S. for the top spot as the world’s largest economy — on average, U.S. investors have only a small allocation of their portfolio directly allocated to emerging markets, usually through an EM or diversified international fund. For example, EM stocks represent approximately 12% of global equity exposure (up from less than 5% in 1994), but only approximately 3% to 5% of current U.S. investor equity exposure.

Using International Monetary Fund (IMF) data, however, one notices that many of those so called small volatile EMs are growing up. Three of the ten largest economies in nominal GDP terms are EMs, with China, India, and Brazil at positions 2, 6, and 8 respectively***. Similarly, by purchasing power parity (PPP), five of the ten largest economies are EM; the ten in order are: China, U.S., India, Japan, Germany, Russia, Indonesia, Brazil, United Kingdom, and France, with Mexico and Turkey close behind.

• By 2030, four of the largest seven economies in nominal GDP terms will be EMs and six of the largest eight in PPP terms will be EMs

Expect emerging market GDP growth of 6% in 2018, up from an annual 5% over the previous three years; for comparison, developed market GDP growth will hover around 2% this year. By 2040, the ten largest emerging economies will be double the size of the ten largest developed economies.

Strategically, there are two main ways for investors to take advantage of this growth.

1. Direct exposure through emerging market investments (EM stocks, bonds, alternatives, and limited partnerships)
2. Indirect exposure through developed economy multinational companies (DM stocks, bonds, alternatives, and limited partnerships) that derive a large or growing proportion of profits or revenues from EM countries

Emerging-market investments typically display higher volatility than developed-market equities; however, this volatility can possibly be mitigated through a discriminating approach to EM investing that targets:

• Less volatile sectors or themes, like the growth of EM domestic demand (a.k.a., the EM consumer)
• Opportunities in smaller EM economies that have a low correlation to the rest of EM
• Private equity or alternative EM investments that are typically priced on a quarterly basis
• DM multinational companies that are growing sales in EM countries

Although difficult to measure, indirect exposure through multinational companies is probably how most U.S. investors have the majority of their EM investment exposure. In other words, one can derive an inherent degree of EM exposure and diversification by virtue of the fact that many of the largest U.S. and international DM firms are focused on selling into EM in a particularly big way.

Thus, with EMs set to (inconceivably) overtake DMs in GDP and economic sway, thinking through EM allocation and exposure should be increasingly important to investor portfolios, especially if down the road one were to reduce exposure to large cap DM multinational companies.

FOOTNOTES

* A reference to the 1973 novel by William Goldman as well as the1987 movie of the same title, “A Princess Bride”

Vizzini: He didn’t fall? Inconceivable.
Inigo Montoya: You keep using that word. I do not think it means what you think it means.

** Developed market economies include Australia, Austria, Belgium, Canada, Denmark, Finland, France Green, Germany, Hong Kong, Ireland, Israel, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Singapore, South Korea, Spain, Sweden, Switzerland, United Kingdom, and the United States.

*** Fun fact: If California was partitioned off, it would be the world’s fifth largest economy.

Michael Ashley Schulman, CFA

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Disclosure: The views and opinions expressed are those of Michael Ashley Schulman, CFA and are subject to change without notice. The views and opinions referenced are as of the date of initial publication, may be modified due to changes in the market or economic conditions, and may not necessarily come to pass. Forward-looking statements cannot be guaranteed; neither can backward-looking nor current-looking statements. This material is provided for informational purposes only and does not constitute an offer or solicitation to purchase or sell any security or commodity or invest in any specific strategy. It is not intended as investment advice and does not take into account each person’s or investor’s unique circumstances. Information has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed. Past performance is no guarantee of future results.