The Past Ten Years in Emerging Markets

 

 

Ben Carslon ( Wealth of Common Sense blog) every year publishes a chart reviewing the performance of 10 asset classes over the past decade. It is a good reminder of how erratic annual returns can be. As shown in the chart below, even though emerging markets performed very poorly over the decade, the asset class was the best performer in three of the years and in the top half of the chart 50% of the time. Commodities were the worst performing asset class, which partially explains weak EM. This chart is U.S.-centric and expressed in US dollar terms, so the strength of the USD  over the period goes a long way to explaining the weak results for EM, commodities and international stocks.

A similar review of emerging markets organized by country is shown below. The returns are not strictly comparable to the previous chart, as these do not include dividends as part of the return. As in the previous chart, the annual returns are erratic and highly unpredictable. However, over the 10-year period, which is long enough to represent two normal 5-year investment cycles or a long 10-year cycle, the results are much less arbitrary.

Valuations do Matter

Though over the short-term valuations are a poor timing instrument, over ten-year periods they are very effective allocation tools. Looking at the Cyclically Adjusted Price Earnings Ratio (CAPE), which averages  inflation-adjusted earnings over the ten-year period, we can see that much of the performance differences can be attributed to the starting and ending points of valuations. The CAPE ratios for 2007 and 2017 are shown below. It must be noted that 2007 ended with very high valuations in most emerging markets, as this was the peak of U.S. Fed-induced “easy money” and commodity prices.

In  our sample, only the USA  (S&P 500) had an expansion in its CAPE ratio, and this explains almost all of its absolute and relative returns for the period. The best performing emerging market, Thailand, had a flat CAPE ratio, while every other market had a contraction in its CAPE ratio. The better performers had smaller contractions in their ratios, with the exception of Indonesia. The worst performers – Russia, Brazil, Turkey, Malaysia — had huge contractions in their CAPE ratios. Though India experienced a period of very high GDP growth and political stability, it could not overcome the anchor from its extreme valuations at the start of the period.

Commodities and Currencies Matter in Emerging Markets

The past ten years was a period of dollar strength and commodity weakness, both of which are correlated to poor performance for the EM asset class. With the exceptions of Indonesia, Peru and South Africa, all commodity-sensitive countries did poorly. Indonesia and Peru were supported by the large size of financials in their indexes, and South Africa is an anomaly because its market has become more correlated to China technology (Naspers-Tencent) than to the domestic economy.

And so do Politics and Governance

Russia, Brazil and Turkey all suffered from severe political instability during the period. Russia’s war with Ukraine and the following economic sanctions, Erdogan’s radicalization of Turkish politics, and Brazil’s economic mismanagement and corruption scandals, were all self-inflicted disasters that could not have been anticipated at the end of 2007.

 

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