Let’s imagine Plutus, the Greek god of wealth, was feeling so benevolent at the beginning of 2016 that he let all emerging market investors in the land know the following events would occur with certainty in the coming year: 1) growth concerns and threats of currency devaluation in China would shake the emerging and developed markets alike; 2) drastic declines in oil and commodities prices would follow; 3) a faction of the Turkish Armed Forces would attempt a coup d’état in Turkey; 4) Brazil would suffer a shattering political scandal (leading to President Rousseff’s impeachment) and a debilitating outbreak of Zika; 5) Donald J. Trump, after campaigning on a highly protectionist platform, would be elected President of the United States; and, finally 6) similar to what happened in Brazil, the Korean president would be impeached. Most investors, after falling to their knees in thanks for this prescience, would likely have moved quickly to take all their capital out of emerging market investments and then waited for the ensuing carnage. Would that have been the right call? Absolutely not. While emerging equities (and debt, for that matter) displayed volatility during the year due in large part to those headlines coming true, they delivered solid returns of 11.2%, considerably outperforming global equities.
Emerging market value stocks did even better, generating gains of nearly 15% in 2016 as shown in the chart below. As is often the case, especially with emerging markets, an asset priced for horrific news can do just fine even when faced with bad news. By the way, Brazil was the best performing stock market in the world in 2016. Arjun Divecha, the head of GMO’s Emerging Markets Equity team, is fond of saying that in the emerging markets “You make more money when things go from truly awful to merely bad, than when they go from good to great.”
In the chart “Emerging markets trade at a big discount to developed markets,” the blue line indicates that things are not all good or even great in the emerging markets. Return on equity (ROE) for the asset class has been declining for years relative to the developed world. After years of superlative performance during the height of the commodities super cycle, ROEs for the emerging markets offer 13% less than their developed counterparts.
While falling relative ROEs may lead some investors to sell emerging market equities, we believe they should trade at a discount to their developed brethren because of their higher levels of fundamental risk. Developed countries separate themselves from emerging countries based on the durability of their institutions. Strong, weak, dynamic, or dull leaders come and go, but developed countries’ key institutions have lived on. Emerging countries don’t offer such consistency and are prone to chaotic and highly dilutive events. As such, a discount of about 10% seems appropriate to us, but today that discount has swelled to a whopping 30% as the gold line in the chart above suggests. Recently, investors have rightly been concerned about a variety of issues in the emerging markets, most significantly the radiating effects from slower than expected growth in China. The election of Donald Trump has further intensified these anxieties.