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Developing Story

Jonathan Clements  |  June 15, 2019

I’M A FAN of emerging stock markets—for two key reasons. But I also have qualms—for two key reasons.

Readers frequently write to me about emerging markets, and those messages usually coincide with periods of stomach-churning volatility, which is what we’ve witnessed recently: MSCI’s emerging markets index tumbled 15% in 2018 and was up just 4% in 2019’s first five months—after being up as much as 14% earlier this year. But as I tell my nervous correspondents, I view emerging markets as a permanent part of my portfolio and I fully expect them to be great long-term performers.

The No. 1 reason for my optimism: demographics. As of 2020, developed nations will have three people of working age for every person age 65 and up, according to United Nations figures. By contrast, in the developing world, there will be 7.7 working-age people for every senior—a far more favorable dependency ratio and a key reason emerging markets will enjoy faster economic growth over the next few decades. Developing economies have young, large, fast-growing working-age populations, plus they don’t have the financial burden of supporting substantial numbers of retirees.

The other reason for optimism: valuations. Even though emerging markets should grow more rapidly than the developed world in the years ahead, their stock markets are far cheaper. Depending on the measure you look at—price/earnings ratios, Shiller P/E, price to cash flow, and so on—emerging stock markets are 20% to 35% cheaper than developed markets.

But offsetting these two key advantages are two major worries. First, investors in emerging markets may see their claim on the economy’s profits constantly diluted. This dilution can occur in two ways. First, publicly traded companies may issue new shares to finance their growth, so existing shareholders own an ever-smaller percentage of these companies. Second, even if an emerging economy is growing rapidly, the fastest growth may be among private companies. These companies may eventually come public—but, at that juncture, their fastest growth may be behind them.

One startling statistic from a recent Financial Analysts Journal article: Over the two decades through 2017, China’s real per capita GDP grew 8.2% a year—but its stock market’s real return was just 0.7%. Because of dilution, there’s often scant connection between a country’s economic growth and its stock market’s performance.

That brings me to my second major worry: Property rights aren’t as firmly established in emerging economies as they are in the U.S. and other developed nations. In the past, I’ve always figured that most developing countries would think long and hard before seizing the assets of foreign investors, because they would face the wrath of the developed world.

But my confidence on that score has waned somewhat and, once again, it relates to China. MSCI—one of the leading creators of market indexes—recently increased the allocation to China in its emerging markets index. Because of that decision by MSCI, and similar decisions by other index designers, many index funds now have around 30% of their holdings allocated to China. I see that as a cause for concern.

Why? If there’s one emerging economy that’s big enough to push back against foreign pressure, it’s China. We’ve seen that during the current dispute with the U.S. over tariffs. Don’t get me wrong: I have no reason to think China will abrogate the rights of foreign shareholders. But if it did, I doubt the U.S. could bully China into backing down.

What’s the solution? I’m not sure there’s a good one, except to keep the above issues in mind when settling on your allocation to emerging markets. I continue to believe that emerging stock markets hold out the possibility of fabulous long-run returns. But high expected returns come with high risk—and, in the case of emerging markets, that risk goes way beyond market volatility.

Follow Jonathan on Twitter @ClementsMoney and on Facebook. His most recent articles include Where It GoesDown the Drain and Great Debates. Jonathan’s latest books: From Here to Financial Happiness and How to Think About Money.

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