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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a senior visiting fellow at the London School of Economics and a former global strategist at Pimco and Moore Capital
As the Fed moves towards rate cuts, some have heralded the imminent resurgence of “emerging markets”. But what are they referring to? Kenya or Qatar? Korea or Colombia? Commodity exporters or tech titans?
Whether in equities or in bonds, the term “emerging markets” no longer does justice to the wide array of constituents within the various EM indices created to attract investor interest in the first place.
What is the best definition of an emerging market? It is every country bar 10 “legacy” advanced economies. The EM residual accounts for 87 per cent of all countries, 85 per cent of the world’s population and just under 50 per cent of global GDP. And it accounts for roughly a third of global financial assets, according to Jon Anderson at EMAdvisors Group. In a sense, the current EM definition designates almost everyone while defining almost nothing (except hope).
The creation of investable emerging market indices starting in the late 1980s marked an important step in mobilising foreign portfolio investments to developing economies. Deepening trade globalisation and rising foreign investor interest in EM were mutually reinforcing.
But it is increasingly unhelpful, if not misleading, to make the case for one of the benchmark emerging markets indices because their constituents would fail basic tests of similarity of asset behaviour and diversity of returns.
At the extreme, the current suite of benchmark indices is downright harmful because a country’s economic and financial performance must go to negative extremes before the country falls out of the index. At various points in the past 25 years, Argentina, Venezuela, Turkey, Nigeria, Egypt and Ukraine have all been examples of countries that continued to receive residual inflows as part of the benchmark indices in spite of unsustainable economic policies.
For prospective index-based investors, China is an elephant in the room. It may not carry its economic weight in the various indices but its economic dominance and, more importantly, its distinct financial drivers set it apart from every other country in the index. The key point is not that China is too big or dominant in the investable equity and bond indices (though at nearly 25 per cent of the EM equity index, this is still a problem), but rather that the China investment boom, which fuelled such strong growth in commodities demand, ended more than a decade ago.
The other big problem for the EM universe is the dollar, given benchmark indices are based on the US currency. This makes those indices highly volatile compared with overall global benchmarks when the returns of underlying EM assets are effectively “converted” to the US currency. The swings happen in both directions, but with a tendency towards extremely negative returns during periods of risk aversion. Accordingly, EM indices are often rented but rarely bought for the long-run.
There is also a single faulty premise on which EM investing has been based: eventual convergence towards rich-country levels of income. Economic growth outperformance was supposed to drive EM currencies to appreciate in real terms relative to their developed peers, thus turbocharging EM asset outperformance in dollar terms.
As Anderson has shown, once China is removed from the sample, EM ex-China’s share of global GDP has been stuck at 28 per cent of GDP since 1960. Since 1980, the only EM economies to converge by more than 1 percentage point relative to America’s income level are China (53 percentage points), India (7 points), Korea (4 points), Indonesia (2 points) and Singapore (2 points). Unfortunately, there was no investible index for these markets.
So what is a prospective investor to do? Rather than throwing the baby out with the bathwater, the simplest way to “reform” the EM indices would be to demand index products that partially insure against the dollar. Backtests over various time horizons show that EM index returns are consistently higher when funded against a 50/50 basket of dollars and euros rather than fully in the US currency.
Second, there should be a shift from a broad-tent index that includes the equivalent of jewels and junk in favour of a suite of customisable thematic investment baskets. Investors need better ways to distinguish between the myriad themes on offer within EM. Embracing the diversity of the country group currently known as emerging markets requires retiring the descriptor itself. It is giving the asset class a bad name.