The long-term role of emerging markets

Over the past decade, returns from emerging market equities and debt have compensated investors well for the higher volatility that investment in these asset classes continues to entail.

Yet many institutional investors’ portfolios remain significantly underweight in emerging market assets.

In the US, the average institutional allocation to emerging market equities is 3.6%, while European investors target an allocation of 4%.

The target EM equity allocation was 2% for UK institutional investors1. This compares to a market cap weighting for emerging market equities of 13.7% in the MSCI All Countries World Index, and to a contribution to global GDP growth of 47% from emerging markets in 2010.

Emerging economies account for more than 70% of the world’s population and a steadily larger proportion of GDP.

Fundamental shifts in inflation, tighter monetary policy and a rise in demand for commodities translate into different sources of risk and return for investors.

Our analysis shows that emerging markets are decoupling from developed markets, leading to significant diversification benefits for investors.

The decoupling factor

Before the financial crisis, the theory that emerging markets were decoupling from developed markets was gaining increasing currency.

However, the spike in correlation at the height of the crisis appeared to belie this view, resulting in a loss of confidence in the diversification benefits of emerging markets.

Yet our quantitative analysis suggests that investors may have written off the decoupling theory too easily.

Unconditional decoupling is undoubtedly extremely difficult to observe between regions, especially during periods of financial stress.

There is evidence of decoupling between emerging and developed economies, since even in the turmoil of mid-2007 to mid-2009 emerging market GDP growth was consistently higher, exceeding developed economies’ growth by an average of 5%.

But economic decoupling didn’t necessarily translate into financial market decoupling.

In the early days of the financial crisis, emerging market equities appeared somewhat impervious to movements in developed markets, but as the crisis deepened they succumbed, and fell much further than developed market equities.

However, while correlation analysis is useful in discerning short-term trends, it can disguise underlying long-term linkages that may exist, dissipate or vary between time series.

We have therefore carried out an econometric measure of co-movement called co-integration analysis, which not only reveals what correlation sometimes hides, but also gauges whether two variables (for which historical values are known) share a long-term, stable relationship.

Exhibit 1, above, shows the long-term co-movement between emerging market and global equity prices on a rolling five-year basis.

The horizontal line represents the statistical threshold below which we conclude there is no significant long-term co-movement.

Values above this threshold indicate recoupling between equity markets.

Our analysis appears to corroborate the argument that emerging and global equity markets recouple during extreme global market events.

The co-movement trend line moves into recoupling territory in the aftermath of the Russian default crisis of 1998, as well as during the financial crisis.

Barring extreme market distortions, however, there is little evidence of consistent longer-term price co-movement.

In other words, there is evidence of a long-term decoupling of emerging and developed equity markets, especially in ‘normal’ market cycles.

Co-movement analysis for emerging and developed market debt tells a similar story.

The diverging economic drivers of emerging and developed market assets therefore do result in portfolio diversification benefits overall – an important reason to support a strategic allocation to emerging markets in a long-term portfolio.

The value added by emerging markets

The benefits that emerging market equities and debt bring to a portfolio are confirmed by our proprietary Non-Normal Market Return Model, which we employ to analyse downside risk.

In addition to considering standard deviation, which assumes a normal distribution of returns and does not measure the potential severity of negative outcomes, our model employs conditional value at risk (CVaR95), defined as the average real portfolio loss (or gain) relative to the starting portfolio in the worst 5% of scenarios, based on 10,000 scenarios.