Investor underexposure to emerging markets (EM) ignores the longer-term direction of the global economy, concludes a new analysis by Forward Management.
The result is a missed opportunity to experience favorable valuations in the short term. The report, What’s Next For Emerging Markets? Seeking a Clear Path Through the Turmoil, suggests that investors consider metrics such as growth in share of global GDP (gross domestic product) and the ratio of market capitalization to GDP as they assess EM growth prospects.
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Based on these measures the report concludes that investors might consider allocating 18% to as much as 43% of their equity portfolio to emerging markets.
Nathan Rowader, Forward’s director of investments & senior market strategist, who authored the study, said: "The global economy has shifted fundamentally. In just 25 years, emerging markets’ global economic share has risen from 1% to one-third or more, and they are forecasted to continue growing more rapidly than developed nations. By those measures, I would estimate most investors are underweight emerging markets."
Allocating to Emerging Markets
The question of how much to allocate to EMs is complicated by shifting methods of measuring the global economy, Rowader said. Based on market capitalization, the measure most commonly used in the past, emerging markets account for roughly 18% of the global economy.
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By GlobalDataHowever, EM nations’ share of global GDP may be a better reflection of their growing economic muscle, the report states. At the end of 2012, EM countries accounted for nearly 32% of global nominal GDP in current US dollars, outstripping the US economy’s 22% share. When nominal GDP is adjusted for purchasing power parity, EM nations account for 43% of the global economy and the US for just 19%.
Investors should also consider ratios of market capitalization-to-GDP since EM equity price and GDP trends will likely converge over time as EMs become more tied to the global economy, the report suggests. At the end of 2013, EMs had a market capitalization-to-GDP ratio of 0.37 while the U.S. ratio was 1.14.
Rowader added: "This tells us EM equity markets have a long way to go before they fully reflect the economic power of emerging nations. Investors may be able to benefit from this convergence."
These measures of emerging markets’ share of the world show that investors who want to better align their portfolios with global growth trends might consider allocating a minimum of 18% and as much as 43% to emerging markets, concludes the analysis.
Emerging Markets Volatility
The report warns, however, that investors should expect volatility in emerging markets and consider diversification or hedging strategies that could potentially mitigate that risk. It also suggests that investors explore active management approaches that can be discriminating in pursuing EM opportunities while also bringing risk management skills to bear.
Alan Reid, CEO of Forward, said: "Investors understandably have been put off by last year’s decline in EM indexes and fears of slowing growth in China, India and Brazil. But we believe the downturn presents an important opportunity, especially for those who can be selective and tactical rather than taking a simple indexing approach."
Emerging Markets Valuations
Emerging economies are expected to grow at a real rate of 4.3% annually over the next 10 years as compared with an expected growth rate of 2.7% in the US, the report states. It also cites forecasts predicting long-term earnings growth of 14.7% for the MSCI Emerging Markets Index versus 13.8% for the US and only 7.5% for Europe.
The report describes current valuations as "compelling," even when looking at index valuations alone. As of February 28, 2014, the MSCI Emerging Markets Index had a price-earnings ratio of 11.2, as compared with 18.7 for the MSCI USA Index and 20.8 for the MSCI Europe Index.
Forward has been active in developing strategies for global and emerging markets exposure. Its offerings include mutual funds focused on dividend-paying EM equities, EM corporate debt and frontier nation equities, as well as funds providing EM exposure as part of global dividend, global infrastructure, world allocation and diversified income strategies.
