When the Financial Times asks the question “Does investing in emerging markets still make sense?” and implies “no” in its answer, the question is loaded. Why? Because China and India are excluded from the FT’s group of slow-growing EMs.
This exclusion hints at the nature of the problem . . . and suggests its solution. The widely used MSCI EM equity index as currently constituted is far too varied to be truly meaningful for investors and contains within it “a giant panda in the room”: China.
EMs as an investment class are fast approaching a watershed. The incremental approach that heretofore has allowed for updates to the EM index “operating software”, so as to reflect the evolution of its constituent markets, has run into overtime. What is required is a fundamental overhaul of how we think about classifying the various and increasingly varied markets in this country grouping.
This reformulation will not undermine the validity of the wider EM asset class. Far from it: indeed, it is the outsized success of some EM countries that demands this overhaul. My proposal envisages investors henceforth being presented with two asset classes for the price of the current one.
As each class will have its own far more logical risk-reward profile, this division will add to the choices that investors face and substantially clarify their options. As a result, each sub-set would be a more attractive asset class. Besides, it is extremely unlikely that developed market (DM) investors will satisfy their demands for income and capital returns in the 2020s without accessing opportunities in EMs.
The following suggestion works immediately for EM equities but — as the developed world’s bond markets are sucked into the black hole of negative yields, a hole from which no income light radiates — it is likely soon to be appropriate for EM fixed-income investing too.
In the benchmark MSCI EM equity index, China is already weighted at 32 per cent, a total set to rise fast in the next few years as the staggered admission of its domestic market continues. Add India and the duo total more than 40 per cent. Add in Korea and Taiwan — both of which should have graduated to a more developed index, Korea being larger than Spain, Taiwan larger than Sweden — and this Asian quartet amounts to 64 per cent of the EM index. The rest of Asia accounts for a further 11 per cent, creating an Asian total of 75 per cent. Russia, eastern Europe, Africa and Latin America share the remaining 25 per cent.
The simple fact is that Asia’s leading mainland economies have become too big for their old-style EM equity breeches.
Investors have faced this sort of dilemma before. In the 1980s — when the Japanese stock market bubble left the Tokyo Stock Exchange of 1990 with 60 per cent of world market capitalisation — “too big” Japan was excluded from most world indices: the “world ex-Japan” index became known as the Kokusai. No one is today suggesting that China’s stock market is in a bubble: rather it is simply too big to be accommodated in the EM index in one go . . . hence its staggered entry. Yet deep down most investors see even this gradual approach as a “faulty patch”: something more radical is required.
If China becomes the world’s largest economy in the next decade as most observers think likely, should it really still be classified as an EM? And if it is, will China have become the gigantic panda in the bath of the MSCI EM index? A solution to this impending paradox needs to be sought and, for investors, the sooner they have a sense of what that solution might look like, the better.
Perhaps what is needed is the creation of a standalone Asian index to be excised mostly from the MSCI EM index. For equities, its initial country constituents would be China, India, Korea and Taiwan. Singapore and Hong Kong might even be added back from the DM index. As and when further Asian nations qualify — Thailand, Malaysia and Indonesia would be next in line — they would be added to this Asian Index. Or they might even be included ab initio.
For fixed income, a similar regional solution might be constructed, but only over time. A number of the main EM bond indices used — the JPMorgan GBI-EM Broad Diversified Composite, for example — feature caps, as individual countries are otherwise deemed too big. In the latter index, the Chinese and, for now, still less sophisticated Indian bond markets each weigh in at a maximum of 10 per cent; Indonesia, at 8.9 per cent, is edging towards being capped. Some indices — the JPMorgan GBI-EM Global Diversified Composite, for example — exclude China and India altogether.
In answer to the FT’s central argument that questions the rationale for investing in EMs, the GDP and productivity growth for nearly every Asian nation named has well exceeded that of DMs post-2000. This not merely negates the logic that one cannot invest in this Asian group because of their economic underperformance relative to DMs; rather it would reinforce the rationale for doing so. As it is, the contention that there is a tight correlation between growth and investment returns is widely contested. What few contest is that the 2020s are likely to offer ample opportunities for both income and capital gain in the world beyond DMs.
The question that then remains is, where does this leave the residual, largely non-Asian EM asset class?
The answer has two parts. For fixed income, the residual EMs will offer yield in an otherwise yield-denied world. Within five years, it is distinctly possible that the US Treasury market will enter the black hole of negative yields, and — post the settling down of the Brexit fallout — so too will UK Gilts; the bond markets of nearly every other developed nation are already in or on the edge of that abyss. EM bonds — both Asian and non-Asian — will then offer what DMs will not: income, albeit at a higher risk. For equities, the EM residuals will offer deep value, value that will probably be realised either when the US dollar is weak — a near-term possibility — and, as would then be likely, commodity prices run.
As a final aside, in such a fluid and fast-changing investment landscape, where previously unknown and so unresearched investment opportunities would be presenting themselves almost daily, it is hard to imagine the active investment manager not being able to harvest alpha, both from stock selection and asset allocation.
The FT’s article highlights the need for a shake-up in the way DM investors are forced to look outside the developed world. Scratch the surface of this new Asian grouping and you will discover those countries that will — in the next decade — move towards the centre of the investment story worldwide.
Whether the investors in today’s DMs can overcome their home biases and acknowledge this epochal shift by spreading their risk capital more globally will arguably be the great investment challenge of the 2020s.