Executive Summary:

  • Since the end of the financial crisis, emerging market equities have not kept pace with U.S equities. We identified three factors that are affecting emerging market performance
  • We believe investors should seek to reduce their exposure to these three factors by favoring GDP weighted emerging market country allocations over market cap weighted allocations
  • We believe investors may benefit from a more complete China allocation within their emerging market strategy

MAY 7, 2015 – U.S. equities have experienced a remarkable turnaround since the worst point of the financial crisis in March 2009. Over this same period, emerging market equities did not perform as well as their U.S counterparts. We believe there are three significant factors that weighed on emerging market performance that may persist into the future. Based on our analysis we identified a solution that can potentially mitigate these factors. We believe this solution can provide attractive performance compared to other emerging market investment vehicles that are not specifically tailored to meet the new paradigm in emerging market investing.

U.S. equities measured by the S&P 5001, have returned 252% from March 1st, 2009 through April 30, 2015. Over the same time period emerging markets, measured by the FTSE Emerging Market Index2 and MSCI Emerging Market Index3 returned 165% and 156% respectively.

FACTOR 1: U.S Dollar Strength & The Potential Federal Reserve Rate Hike
Since its five year low on July 26, 2011 through April 30, 2015, the Bloomberg Dollar Spot Index4 returned 28.95%. While the dollar has strengthened, some individual emerging market (EM) currencies have depreciated significantly as illustrated by the second chart below. This foreign exchange exposure hurt market cap weighted EM indices due to their overweight to several of the worst performing currencies. The specter of a potential rate hike from the Federal Reserve could exacerbate this situation because when rates rise in the U.S. the dollar typically strengthens.

FACTOR 2: Increased U.S. Energy Production
Increased U.S. energy production is a contributor to the collapse in global oil prices. Lower oil prices hurt the economies and stock markets of many emerging market exporters such as Brazil, Mexico and Qatar. The trickle down effect of lower prices on these economies has been severe. Market cap weighted emerging market indices have high weights to these countries.

FACTOR 3: China’s Slowing Fixed Asset Investment
China’s rate of fixed asset investment has been slowing in recent years. Fixed asset investment (FAI) is an economist’s term for building assets that are held for ten years or more. If China is building at a slower rate, less commodity inputs are needed. China is the largest trading partner for many emerging market countries that rely on it to buy their commodity and natural resource exports. If China’s FAI continues to slow, investors can expect a negative knock on effect for these countries. Market cap weighted indices have large exposures to emerging market countries that depend on China to buy their resources.

South Africa: a Surprising Exception to the New Emerging Market Paradigm
According to our thesis, we believe South Africa should perform poorly because it is heavily exposed to the three factors we outlined above. Quite surprisingly, South Africa has performed well compared to many other EM countries over the past five years. The reason for this outperformance can be attributed to Naspers– the largest listed company on the Johannesburg Stock Exchange. Naspers is a giant South African media conglomerate that was an early investor in Chinese internet giant Tencent. From April 30, 2010 to April 30, 2015, Naspers returned 307%5 driven by the strong performance of Tencent’s stock on the Hong Kong Stock Exchange6. Over this time period Naspers contributed 20% of the MSCI South Africa Index’s 43% return7. South Africa is an exception to our thesis because nearly half of its return was actually driven by Tencent– a company that trades 6,600 miles away in Hong Kong.