Investors need to stop treating emerging markets as one ‘blob’ and consider making more single-country allocations if they want diversification and returns, according to Kepler Trust Intelligence’s Callum Stokeld has warned.
The broad range of emerging markets to invest in has grown in the past few decades as developing countries have lowered barriers to entry and allowed foreign money to come flooding in.
The increased weighting of Chinese stocks in emerging market benchmarks and the inclusion of Saudi Arabia have been met with greater flows to those countries.
Nevertheless, some investors still prefer their exposure to these economies to be more broad-based, with some £27.2bn invested in the IA Global Emerging Markets sector.
However, investors should be wary of treating emerging markets as a broad geographical allocation.
“It is something of a truism to say that emerging markets are not a homogenous blob, but a range of highly differentiated economies and stock markets,” said Kepler analyst Stokeld.
“Yet as investors, we often categorise them as one and the same, especially from an asset allocation and risk management perspective.”
He added: “Increasingly, divergences can be seen in how these markets correlate to one another as they mature.”
The Kepler analyst said while Asia-Pacific and global emerging market strategies are typically merged into broad asset classes, single market exposure to underlying market may give more effective diversification.
The make-up of emerging markets benchmarks has changed considerably over the past decade. However, the data below shows how the largest constituents in the MSCI Emerging Markets benchmark are not as correlated to the index as some may thing.
Rolling monthly 3yr r-squared of indices relative to MSCI Emerging Markets over 5yrs
Source: FE Analytics
Using the r-squared ratio – a measure of how closely correlated two indices are – Kepler found that indices “have exhibited a general trend of declining correlations” over the past decade with the exception of China, which has seen its increase significantly over the period.
“Apart from China, all the major emerging markets – including Hong Kong – show a clear decline in their r-squared to the wider benchmark,” said Stokeld. “However, this still tells us little of the dynamics which drive these different markets, or how they correlate to wider global equity markets.
“Clearly each country has very different listed equity markets, composed of very different industries. Sector exposure can therefore be regarded as a driver of relative performance in different macro environments.”
As the below chart shows, there are substantial differences in sector allocations at a country level in the MSCI Emerging Markets index.
The analyst said that while industry factors may help drive shorter-term performance, internal drivers will become increasingly important “as economies develop, real wages rise and populations age”.
“Different countries and regions will be inevitably and increasingly subject to internal drivers of returns,” he said.
Below, Stokeld takes a closer look at several emerging market countries and regions to determine what is driving returns.
China
China, which has the highest correlation to movements in the emerging markets index, is not as correlated to movements to its peers in the BRIC club (Brazil, Russia, India & China), says Stokeld.
The analyst said the Chinese market has a greater correlation with Korean and Taiwanese markets, which are more export orientated and “are often perceived as being tied to global trade volumes”.
Rolling monthly 3yr r-squared of indices relative to MSCI China over 5yrs
Source: FE Analytics
Chinese authorities’ capital controls also restrict the ability of domestic savers to allocate overseas, he said, and therefore have a very strong domestic bias.
“In recent years, this has facilitated rallies in asset markets as and when the authorities make credit more readily available, but it has been noted that these often tend to vary between different assets at different times,” he added.
“Accordingly, Chinese markets have frequently been driven by changes in domestic monetary conditions, and microeconomic policy decisions affecting the relative desirability of shares compared to property.”
India
Another BRIC member, India has “unsurprisingly, consistently low” correlations to other emerging market given the importance of domestic drivers – such as demographics and savings.
“Indeed, investors’ primary concern in recent years has been the varying expectations of the Modi government’s success – and to what degree – in reducing the role of the state in the economy and pursuing more free-market economic policies,” said Stokeld,
“Similarly, domestic inflation expectations often impact the relative attractiveness of bonds to equities, particularly to domestic investors.”
Latin America
Latin American markets, said the Kepler analyst, are dominated by the Brazilian and Mexican markets, which represent around 63 per cent and 20 per cent of the regional benchmark respectively.
“The drivers of Brazilian markets have become increasingly internal in recent years, though political noise around potential tariffs has seen the Mexican market diverge from this pattern,” he said.
“As with India, investor sentiment in Brazil has mainly centred on perceived political developments. After enduring the worst recorded recession in Brazilian history in the early 2010s, investor confidence has tentatively started to return.”
Eastern Europe
Like the Latin American market, Eastern Europe is dominated by one big player: Russia.
“The declining correlation of eastern Europe to wider emerging markets comes against a backdrop of ratcheting geopolitical tensions between Russia and the west,” said Stokeld.
“Over the past 10 years, the Russian economy has experienced significant internal turbulence, including sharp interest rate rises to stem capital outflows following the imposition of sanctions.”
Rolling monthly 3yr r-squared of indices relative to MSCI Russia over 5yrs
Source: FE Analytics
The Kepler analyst added: “It is debatable whether, following these events, Russia will start to align more closely again with the global economy and global markets.”