In the last 10 years, world growth did not start in the West, nor did equity market performance; these have been more or less flat for a decade. Instead, emerging markets yielded 70% to 100% of world growth, depending on the year. Average portfolios of Western clients, however, have not reflected this fact.
Europe is now in its worst crisis since the inception of the euro. The outcome could yet be very nasty. The US has struggled with poor growth since the 2007–2008 financial crisis; this may go on indefinitely. Japan has never recovered from the burst of its stock and housing bubbles some 25 years ago. There are not many places to hide in the developed economies. They also face high public debt as well as the challenge of over-aging societies.
While emerging markets now generate 50% of world GDP when measured in purchasing power, this amounts to merely 30% when measured with market exchange rates – showing that their currencies are still massively undervalued. Data from Capgemini, however, show that portfolios in developed economies have between 85% and 95% of their assets invested in developed economies, with a significant portion in home markets. US investors invest in the US, Germans in Germany, the Swiss in Switzerland. This “home bias” can be seen as one cause for poor portfolio performance over the last 10 years.
People tend to buy what they know; they consider what is farther away more risky. This attitude has some merits. Currency risk, costlier information gathering, tax and legal concerns can arise. But even accounting for those factors, there remains a systematic underweight of emerging markets in portfolios of developed market investors. Two misconceptions might explain this: hindsight bias and a traditional apprehension toward very volatile assets.
Past performance is no guarantee for future performance, so one cannot argue that emerging markets have performed absolutely, well ahead of developed markets over the last decade, and so project future returns. Nevertheless, the future appears favorable for emerging markets. Many are converging towards the developed economies, so their growth rates will go on outperforming in the long run. Encompassing setbacks and conservative growth assumptions, one still arrives at forecasts that emerging markets will account for 65% of the world economy by 2025 and 75% by 2050.
As for volatility, politics, the rule of law and corruption still mark many emerging markets. But in the US and in Europe of late we have also wanted for political leadership, visibility and accountability. In fact, considering the financial crisis which hit the US in 2007–2008, and the sovereign debt crisis which is currently unfolding in Europe, emerging market investors are far less dazzled and confused than developed economy investors, since those crises appear familiar to them.
Don’t get me wrong, I am not pleading for a large-scale shift of assets from developed to emerging markets, but leaving the usual comfort zone and seeing emerging markets with new lenses is in my view likely to be rewarding from a risk-return perspective.
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