Emerging Markets: Diminishing Risks vs. Headline Fears

Fears of new threats to emerging markets have cooled stock returns after two years of hot performance. But the concerns may be overstated. The long-term risk profile of emerging markets is continuing to improve.

Growing risks to emerging markets are making headlines. Turkey’s currency crisis, expectations of US interest-rate hikes and a stronger US dollar are seen as big threats to developing markets. US–China trade tensions have added to the anxiety. The MSCI Emerging Markets Index has dropped by 1.2% in US-dollar terms through June 13 after surging by a cumulative 52.6% in 2016 and 2017. Investors withdrew $2.7 billion from US-domiciled emerging-market (EM) equity funds in May, reversing 17 consecutive months of positive flows, according to data from Morningstar.

The panic may be premature. When viewed through a long-term lens, we think macroeconomic and market fundamentals provide solid ground for EM companies to deliver results—and for investors to prosper.

EM Volatility Has Been Declining

Headlines about EM risks are unsettling, yet they tend to obscure declining volatility in EM stock markets. In the past, EM stocks were more volatile than developed-market stocks, as investors perceived them to be much riskier. But even though US market volatility spiked this year, EM volatility has been relatively subdued (Display).

Why the change? Consider the composition of the benchmark. Over the last 10 years, the weight of highly cyclical sectors such as energy and materials in the MSCI Emerging Markets has dropped dramatically (Display). Meanwhile, technology stocks have become the largest sector weight. This change has reduced the economic sensitivity and risk profile of EM equities. Yet the MSCI Emerging Markets trades at a price/forward earnings ratio of 11.6x, a 25% discount to global developed stocks, suggesting that investors still believe developing stocks are significantly riskier.