A sharper emerging-market picture

The dispersion of EM countries across several dimensions has potential implications for investors

A sharper emerging-market picture

For many emerging-market (EM) equity investors, the ability to get immediate broad exposure through indexes might be beneficial. But as EM indexes have grown into a more diverse set of countries, they may want to consider a more discriminating approach.

“When we introduced the MSCI Emerging Markets Index in 1988, it covered 10 countries and represented less than 1% of the global equity market, as reflected by the MSCI ACWI Index,” wrote Jean-Maurice Ladure, executive director and head of Equity Solutions Research, EMEA at MSCI, in a recent blog post. “Fast forward three decades and the index comprises 26 countries, representing 12% of global equities.”

Over that time, according to Ladure, EM countries outperformed the MSCI ACWI Index by an average of 250 basis points per year. That supports a case for investors to devote part of their portfolios to EM, with those harbouring strong convictions and bottom-up views tending to prefer active managers.

“However, an investor with strong convictions might consider an approach allowing tilts toward or away from specific themes,” he said, suggesting active allocations to single-country index-based funds.

Examining the variation of returns across different EM countries, Ladure said that the gap between the best- and worst-performing EM countries over the three years ended July 31, 2019 was 40% — double the variation observed for developed markets — suggesting that single-country concentration of positive returns was more pronounced for developing markets.

Looking at the cross-sectional volatility (CSV) of the EM stock universe showed a similar difference. Across three systemic factor categories — countries, sectors, and styles — showed that countries accounted for over 60% of the contribution to CSV over a 20-year period, while both sectors and styles contributed less than 20% for the majority of the period. In contrast, all three factor categories had similar CSV contributions to stock-return dispersions in developed markets.

“Given the large role of country exposure, we examined the potential effect of macroeconomic events, such as the current U.S.-China trade war,” Ladure said.

An analysis of different EM markets’ level of exposure to the U.S. and Chinese markets revealed that Chinese markets were almost totally domestically oriented, with over 90% exposure to China. Meanwhile, South Korea and Taiwan had the most sizeable exposures to both China and the U.S. among a sample of 9 large EM countries.

“The U.S.-China trade war may also have an impact on EM currencies, whether directly if a country embarks on currency depreciation or indirectly if the trade war triggers an economic slowdown,” Ladure said. “In particular, the weakness or strength of the U.S. dollar historically had implications for countries such as Taiwan, Russia and Brazil.”

Based on an evaluation of one-year rolling periods from 2006 to 2019, he said that an equal-weighted mix of Russian and Brazilian equity markets tended to underperform vs. Taiwan when the trade-weighted U.S. dollar strengthened against major currencies, and vice versa.

Oil prices were another significant macroeconomic variable, particularly for large commodity-producing members of the EM universe. Referring to MSCI’s Barra Emerging Markets Model, he said that EM countries have different exposures to oil, with producers historically outperforming importers when oil prices rose.

“Many EM equity markets showed wide dispersions of reaction to certain macroeconomic variables such as economic exposure, currencies and commodities, which can be affected by major global events,” Ladure said.

“Approaches based on single-country indexes may allow investors to express their views on specific themes.”