Low debt exposure leads to strong performance relative to developed markets.
There is no doubt that institutional investors have felt the pain of the global credit crunch. Portfolios have suffered as investment vehicles making extensive use of securitization, such as mortgage-backed securities and collateralized debt obligations, faltered. With banks unwilling to lend to one another and corporations having difficulty raising funds, an extreme lack of liquidity has posed a major economic danger, weighing heavily on global markets.
Fortunately, however, all global markets are not equal. Despite poor stock performance in developed markets, emerging markets have continued to do quite well. Measured in U.S. dollar terms, the MSCI World Index lost 10.68% for the year ended June 2008, while the MSCI Global Emerging Markets Index gained 4.63%. The five-year returns are even more striking: emerging markets were up 29.71% compared with 11.98% for developed markets.
“One aspect separating Latin America from other regions is that oil reserves are more plentiful there than in Asia-Pacific and some European countries.”
— Joseph Molloy
Portfolio Manager, Global Quantitative Management, Northern Trust, London
The key question is: Why? The growth and development of local debt markets is cited as the primary factor making emerging economies more resilient to the global credit crisis. â€śThis is by no means universal, but those emerging market economies that are the most self-reliant and strong are the economies that have withstood the global financial crisis most effectively,â€ť says Jason Toussaint, senior investment strategist in the Global Quantitative Management group at Northern Trust in London.
Within emerging markets, the economic trends are very positive overall. Foreign exchange-denominated debt, for example, has been reduced from 90% of gross domestic product (GDP) to just 10% in the past decade or so.
“Emerging markets are increasingly well capitalized and have improved their creditworthiness,â€ť says Jenny Bright, senior investment product manager at Northern Trust in London. â€śThe increased self-sufficiency of emerging markets bodes well when the rest of the worldâ€™s financial markets are experiencing difficulty.”
“The increasing number of developing countries rated as investment grade by the worldâ€™s major ratings agencies is a signal that investorsâ€™ perceptions about country-specific risk are improving.”
— Jenny Bright
Senior Investment Product Manager, Northern Trust, London
As shown in the â€śLoan Exposure Relative to GDPâ€ť chart on page 15, developed market economies tend to have a much higher exposure to debt as a percentage of GDP. For example, the United States has the highest exposure, with loans making up 172% of its total GDP. Among the developed countries listed, Japan is lowest, with 92%. The U.K. and Germany are at 138% and 126%, respectively. Among the emerging markets shown, roughly half have a loan-to-GDP exposure of less than 50%. Only four of these emerging markets â€” Israel, China, Malaysia and Taiwan â€” exceed 100% in their loan-to-GDP exposure.
In another reflection of the maturity and stability of these nations, almost 80% of the countries in the S&P IFCG Global Composite Index, which represents emerging markets, were rated as investment grade as of May 31, 2008.
“The increasing number of developing countries that are rated as investment grade by the worldâ€™s major ratings agencies is a signal that investorsâ€™ perceptions about country-specific risk are improving,” Bright says.
“Those emerging market economies that are the most self-reliant and strong are the economies that have withstood the global financial crisis most effectively.”
— Jason Toussaint
Senior Investment Strategist, Global Quantitative Management, Northern Trust, London
These improvements and the historical low correlation in returns between emerging markets and developed markets help explain how thoroughly and extensively emerging market sectors and countries outperformed. â€śThis performance differential â€” whether measured in dollars, pounds or euros â€” has been exacerbated during the past year as developed markets struggle through the credit crisis,â€ť Bright says.
An examination of relative sector-by-sector returns shows where emerging markets outperformance was particularly strong. The â€śSector Performance Drives EM Returnsâ€ť chart to the right shows emerging markets enjoyed a 23 percentage-point advantage in the energy sector, an 18-point margin in telecommunications and a 15-point edge in health care.
“Materials and energy stocks were key positives for the MSCI World Index, and their contribution was multiplied in the EM Index,” says Joseph Molloy, portfolio manager in the Global Quantitative Management group at Northern Trust, London. As important, financials were the largest drag on the World Index, but less of a hindrance on the EM Index. The “Sector Weights as Performance Contributors” chart on page 17 shows the weight of key sectors within the EM Index also helped performance.
When comparing performance results for the year ended June 30 on a geographical basis, emerging markets maintained their dominance over their developed counterparts. All regional developed market indices posted negative results, with the biggest loss coming from Europe, which was down 11.34%. In contrast, all but two regional emerging market indices not only posted positive results, but were into double digits.
In particular, Latin Americaâ€™s performance â€” 29.49% â€” stood out. A key element was Brazilâ€™s soaring results: 53.60% and 57.29% annualized returns for the respective one- and two-year performance periods. Brazilâ€™s strong economy and oil wealth were obvious factors. On a broader scale, Latin America overall had very little exposure to the sub-prime securitization and ensuing credit crunch.
“One aspect separating Latin America from other regions is that oil reserves are more plentiful there than in Asia-Pacific and some European countries,” Molloy says.
“Although Latin Americaâ€™s leadership among emerging market regions is noteworthy, there is no way to realistically assume that it will continue, as much as it might appear that way at this point,” Molloy says.
Over a longer period of time, the regional performance of developed markets improved, but emerging markets still maintained their advantage. For the five-year period ended June 30, the performance of developed markets ranged from 8.42% for North America to 22.59% for Nordic countries. During the same time period, the regional performance for emerging markets ranged from 22.35% for the Far East to 46.99% for Latin America.
Emerging markets, by their very nature, are more volatile than developed markets, Molloy says. â€śAs a result, emerging markets lend themselves to a broad, all-inclusive investment approach, such as indexing. That way, an investor has the potential to capture top-performing regions or countries while lowering risk levels through greater diversification.â€ť
In terms of market capitalization, emerging market stocks have a total weighting of 11.58% within the MSCI All Country World Index, which encompasses both developed and emerging markets. Institutional investors can use that weighting to determine their exposure to emerging markets.
“If an institutional investor has significantly less than 11% to 12% exposure to emerging markets, that relative underweighting should be an intentional strategic decision,” says Jason Toussaint, senior investment strategist in the Global Quantitative Management group at Northern Trust in London.
“Even if we ignore emerging marketsâ€™ recent status of outperforming the developed countries in investment returns, they still offer excellent diversification through their low correlation with developed markets, and they are the worldâ€™s economic growth engine,” Toussaint says. â€śThey round out a truly global equity portfolio.â€ť