News & Commentary

Emerging markets returns not all about high economic growth 24 May 10

New thinking analyses the allure of emerging markets

Melbourne, 24 May 2010: Investors have been cautioned about overly optimistic expectations for investment returns from emerging markets.

New research by The Vanguard Group, Inc. sounds a note of caution on expectations that strong economic growth among emerging markets translates to higher earnings potential and share market gains, especially when compared against growth in the developed economies.

Australian investors have been increasingly exposed to the growth potential of emerging markets, with the MSCI Emerging Markets Index posting an annualised return of 10.2 per cent over the past 10 years (to 31 December 2009).

But new Vanguard research reveals investors should think carefully before assuming strong economic growth automatically equates to high share market returns.

The Vanguard Investment Strategy Group paper, Investing in emerging markets: Evaluating the allure of rapid economic growth, analysed the correlation between long run economic growth (as measured by GDP growth per capita) and long run stock returns across 16 major markets. It found that since 1900, the correlation was effectively zero.

“Some investors are reassessing the primary role of emerging markets in their global portfolio from one of diversifying their equity holdings to one of generating higher expected returns relative to developed markets,” said Vanguard chief economist and co-author, Joe Davis.

 “Understandably the allure of emerging markets can be strong, as faster economic growth is typically associated with stronger earnings growth, which is thought to be associated with higher stock returns.”

“However, looking back over the past decade, emerging markets investors were rewarded for the risk they bore not because of high economic growth per se, but rather because of comparatively low equity valuations in the early 2000s.”

While economic growth remains relevant to stock market investors, Vanguard’s research found the relationship between economic growth rates and average stock returns can be influenced by three key factors:

• Growth surprises: It is not consensus expectations, but rather the surprises in actual economic growth based on these expectations that influences stock returns;
• Valuations: the future long-term return on emerging markets investments will depend largely on the price investors pay for a market’s expected growth at any given time; and
• Globalisation: Corporate profits in developed markets are increasingly earned abroad. In the US, corporate profits derived from direct investment abroad have doubled from 20 per cent in 1999 to 40 per cent in 2008. In this way, multinational firms based in developed markets are contributing to emerging market growth.

“Far from warning investors to steer clear of emerging markets, this research reinforces the importance of diversification – both across asset classes and markets – in all portfolios. Diversification aims to spread risk and reduce portfolio volatility, rather than act as a strategy to pick ‘winners’ and ‘losers’”, said Vanguard’s Chief Investment Officer, Joseph Brennan.

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