Emerging market volatility shifts lower

During crises, the volatility or risk associated with EM equities tends to be higher than that of developed market equities, probably because of the interaction between financial crises and economic crises in EMs. When risk aversion sets in, the dollar tends to appreciate, leading to capital flight from EMs. This supports the notion that EM equities inherently carry more risk compared to their DM counterparts. Meanwhile, there is always one crisis or conflict brewing in the developing world, the headlines are rarely positive.

Yet the reality is more complex than the perception of risk. By some measures, EM equity assets have become less risky than DM assets, and the notion that EM equities are little more than a leveraged bet on the most cyclical parts of the global economy is now out of date.

Start by comparing the beta of EM equities to DM equities. Examining on rolling 3-year time frame, the beta of the MSCI Emerging Markets index to its developed market counterpart has consistently remained below one throughout almost the entire history of the index. It is only during the period that includes the GFC that the sensitivity of EM equity returns to DM equity markets clearly exceeded one. One way of understanding this chart is that under normal conditions, EMs tend to be less risky than people think. However, during significant crises, the potential losses in EM can be greater.

Figure 1: Emerging market vs. developed market beta

Source: Bloomberg, MSCI where EM is represented by MSCI Emerging Markets and DM by MSCI World. Calculations by Ninety One, as at 31 December 2023.

In addition, the standalone risk profile of EM equities has changed dramatically. As emerging economies and financial markets have matured, the volatility of their equity markets have shown a steady decline. In fact, in recent years, EM equity volatility has fallen consistently and is now lower than that of developed markets.¹

Figure 2: Emerging market vs. developed market volatility

Source: Bloomberg, MSCI where EM is represented by MSCI Emerging Markets (Local) and DM by MSCI World (Local). Calculations by Ninety One, as at 31 December 2023.

Correlation advantage persists

Next, we can look at correlations. EMs tend to have lower correlations with other equity markets, usually ranging between 50-60%. In comparison, US and European indices show higher correlations, typically around 70-80%. Japan, like emerging markets, has also proven to be a strong diversifier, with correlation characteristics in line with emerging markets.

That matters because the risk of EM assets in a given portfolio requires making a judgment on the total portfolio. As Harry Markowitz² showed in the 1950s, a portfolio’s risk is not solely determined by the average riskiness of its individual assets, but rather by the degree to which the returns on those assets are correlated. In other words, investors don’t need every asset in the portfolio to be lower risk to effectively mitigate the overall risk. So as a starting point, the question of EM risk should be ‘risky to whom’?

We know, for instance, that risk-adjusted returns of EM assets in euros are typically higher than those in dollars given existing correlations of EM assets to euros and dollars. Those lower correlations create the conditions for higher risk-adjusted returns in portfolios through the mechanism of rebalancing.

After examining these portfolio risk metrics, where does this leave investors trying to understand the risk of EM assets relative to DM assets? As discussed earlier, EM equities typically exhibit lower beta values, except during crises, and have seen a declining trend in volatility. Correlations are lower than equivalent assets. In essence this translates to relatively lower standard deviation of returns but with a more negatively skewed and fatter-tailed distribution compared to equities in developed markets.

In other words, in most conditions, emerging markets demonstrably have returns with less volatility when compared with developed markets. However, the tails are fatter. Returns are more likely to have more extreme events, both positive and negative, in their distribution. If the conventional wisdom is “EM is riskier than DM,” the picture is more complex. For investors, it is clear that emerging market equities have some useful diversification properties for advanced economy investors. Reputation and reality have diverged substantially, and that is where the opportunity lies.

¹ This chart is calculated using local currency return across both markets. Measuring returns in a common currency such as the US dollar makes some differences to the levels of these series but all of the specific points made in the text hold in both local currency and US dollar terms.
² Harry Markowitz was best known for his pioneering work in modern portfolio theory, studying the effects of asset risk, return, correlation and diversification on probable investment portfolio returns.

1. Market composition impacts from Chinese IPOs were a major one-time drag on returns, a factor that is still not widely understood. Chinese tech stocks were included in EM equity indices at their peak valuations and then derated spectacularly. This affected returns negatively. It will be difficult for a repeat of this scenario in the future because it would require a return to the pre-Xi era in terms of domestic governance and international relations. In fact, the negative influence of market composition changes has already halved in 2022 and 2023 relative to the past decade.
2. During the 2010s, suboptimal sector allocations weighed down returns as central banks maintained an ultra-low-rate environment and commodities suffered a downcycle. In contrast, returns in the EM technology sector, which now represents 20% of the EM index, were very strong despite their low sectoral weight. Looking ahead, we anticipate that the drag on returns from sectors such as materials, energy, and financials will stabilise, while the EM tech sector will be the home of many winners.
3. The extraordinary opportunity cost of investing outside of US equities created a challenging scenario for investors considering alternatives. In our view, replicating the same level of performance by US equities will be a formidable task as it necessitates surpassing already high expectations.

To be more specific, revaluation contributed significantly to the annual returns in the US over the ten years to September 2023, accounting for a positive 2.8 percentage points per year. In contrast, EM saw a negative revaluation return of -0.6% per annum, and Europe, Australasia, Far East (EAFE) had a -0.2% per annum return in this regard. A core principle of our Capital Market Assumptions approach is that starting valuations are a major driver of long-term returns. Weak past returns make future returns look better (Figure 3).

Figure 3: Return contributions 10 years to 30 September 2023

Source: Ninety One calculations

That suggests current valuations will be a significant headwind, particularly for US equity returns. As a result, we expect the return impact of international diversification over the next ten years to look very different to the experience of the last decade.

Investors do not know which allocations in a portfolio will perform, and which will not. Faced with uncertainty, they should hold a spread of investments that will behave differently, thereby maximising the chance of meeting long-run return objectives across a range of possible scenarios. Even though most portfolios are significantly overweight US assets at this point in the cycle, this was not true just after the GFC and it is not difficult to imagine future conditions in which this will not be true again.

As discussed earlier, Harry Markowitz pointed out many years ago that portfolio risk can be reduced without sacrificing expected return by constructing a portfolio that is not perfectly correlated. Over-concentration of risk in investments with fat downside tail risks — such as equities — is particularly unwise given the additional difficulty of recovering from substantial drawdowns.

The most defensible form of home bias is probably in the US. Vanguard’s Jack Bogle and Berkshire Hathaway’s Warren Buffett have argued that there is a case for investors generally, and especially US investors, to have a structural overweight to the US due to the scale of the economy, the global reach of its businesses, and its robust institutions.

US returns since 1900 have certainly been exceptional.⁴

However, structurally, those returns were underpinned by the fact that the US experience in the 20th century was exceptional. The US achieved unparalleled military, technological, and economic supremacy during the 20th century, with no revolutions, hyperinflation or wars on home soil over the period. In contrast, investors in Germany in the 20th century would have faced near-total capital losses on two separate occasions.

Many investors think that US exceptionalism will continue. And perhaps an argument can be made for home bias among US equity investors: US stocks account for half the global equity indices, and large cap US companies get a third of their revenues from abroad.

However, if a US institution for various reasons believes the future will play out differently from the past, and thus does not want 100% equity exposure to US equities, then diversification makes sense. US institutions may also seek diversification as a safeguard against long periods when US equities underperform global markets, as witnessed in the early 2000s, or during the 1980s.

Meanwhile, for an institutional investor in Europe or Japan diversification will more often be the right decision.

A study by Dimson, Marsh and Staunton attempted to measure the gains for investors in markets where favouring local investments (home bias) proved beneficial and where it wasn’t. They looked at the Sharpe ratios, which show risk-adjusted returns, for investors in various countries with exposure to domestic equities and to a geographically diversified portfolio. Their findings over the past 50 years revealed that, in most countries, investing globally resulted in better Sharpe ratios compared to investing only in domestic stocks. However, there were a few exceptions to this trend. One of these exceptions was the United States.⁵

In other words, diversification beyond home markets has generally worked, with important exceptions.

As we learned in In the Crossfire, it’s evident that EM returns remain competitive against European or Japanese equities most of the time. Notably, EM outperformed EAFE (Europe, Australasia and the Far East) two-thirds of the time since 2001.

Figure 4: How often does EM outperform US, ACWI, EAFE and Europe (1-year rolling)

Source: Ninety One - In the Crossfire, MSCI.

Even in the difficult period from 2011-2021, when Russia went to zero and “Common Prosperity” prompted a revaluation of Chinese assets, EM outperformed EAFE around half the time.

That is a significant finding, even for US investors. Unless they intend to allocate their entire equity portfolio exclusively to the US, EM equities offer a competitive choice alongside other alternatives.

EM cycles have typically closely coincided with the USD downcycles. This relationship has held since the 1990s, when many EM currencies transitioned to freely floating exchange rates. Remarkably, it was also true in the 1970s and 1980s when EM currencies were pegged and managed.

As In the Crossfire highlighted, following a peak in the US dollar, EM equities have typically risen by 30-50% in the following 6-12 months. Similarly, EM local bonds have risen by 20-25% within the same timeframe. This underscores the significance of global currency dynamics on emerging markets.

Figure 5: The relative performance of EM vs. DM equities compared to US dollar strength (1988-2022)

Source: Ninety One - In the Crossfire, MSCI.

The relative outperformance of emerging markets compared to developed markets during periods of dollar decline can be explained by the role of dollar invoicing, the burden of dollar-denominated debt for EM corporates and governments falls, as does the ‘safe asset’ bias towards DM assets.

For global investors, this diversification away from dollar-based assets becomes particularly salient in the context of tail risk scenarios for the global economy. These scenarios might lead to the dollar losing value against the rest of the world at an accelerated rate over the next five to 10 years, potentially exceeding current expectations.

That could result from a dedollarisation or financial deglobalisation scenario that we discussed extensively in 2019 and that has received a renewed impetus since the central bank sanctions applied on Russia after its invasion of Ukraine.

Positioning against this outcome with EM rather than other DM currencies is more likely to provide a positive carry, especially considering the favourable initial yields in EM fixed income.

³ In Pursuit of the Perfect Portfolio, “Starting from Markowitz, we can see that the idea of diversification of a portfolio as a means to reduce risk is universally accepted, but this may be the only thing our experts fully agree on.”
⁴ Dimson Marsh via AQR.
⁵ Dimson Mash

Figure 6: EM vs. DM equity correlation in 2008

Source: Bloomberg, MSCI where EM is represented by MSCI Emerging Markets (Local) and DM by MSCI World (Local).
Calculations by Ninety One, as at 31 December 2023.

Support for ‘decoupling’ was premised on the fact that EMs were maturing and moving to a new phase of development. There is justification for this argument. Just as the US expanded in the 19th century to become an endogenous source of demand instead of an exporter to then-richer European countries, EMs would now grow through domestic consumption, decoupling from the developed economies. In other words, even if the latter fell into a recession, the emerging world would stay on its long-term secular path.

The story persuaded many. The performance of EM assets for much of this period was strong. Coming off a wave of crises in the 1990s that left EMs cheap and supported by relentless commodity demand from a rampant Chinese economy after it joined the World Trade Organisation, EMs exhibited strong economic growth and strong portfolio outperformance.

Yet during that moment of crisis in 2008, when diversification was most valuable, EM assets ‘let investors down’.

The idea of ‘decoupling’ in times of crisis was probably always unrealistic. It is crucial to distinguish between diversification and hedging. Diversification is about improved risk-return outcomes over time, while hedging focuses on downside protection in a crisis.

The global financial system has become increasingly inter-connected in recent decades. A consequence of this is that in major market crises correlations between different equity markets tend to increase dramatically.

However, it’s crucial to understand that a crisis dynamic in markets does not invalidate the importance of long-term portfolio diversification. While short-term crashes are painful, the more significant concern for investors aiming to meet longer term objectives is not the short-term downturns, from which markets inevitably rebound, but the prospect of prolonged bear markets.

It’s worth noting that while equity markets can decline together, economic and market performance can diverge sharply across countries. An extreme example is Japan’s economic boom in the 1980s and its subsequent bust in the 1990s.

Figure 7: MSCI Japan vs. a diversified portfolio for Japanese investors (1990-2000)

Source: Ninety One, MSCI, Bloomberg.