No question about it, 2018 was a year to forget for emerging market investors. The space was hit hard by concerns over tariffs, trade wars, and general political instability. However, it is important to keep this rough year in perspective. Emerging markets easily crushed their American counterparts in 2017 and have been extremely strong when considering long time frames such as since the beginning of the millennium.
So why such a high level of panic this time around? Some investors seem to be forgoing any exposure at all to the space, willing to write off a good portion of the global population from an investment perspective because of one bad year. One would rarely—if ever—see this type of thinking applied to American markets. So, why the concern to the point of abandonment for emerging markets?
It could be because most investors recognize that the U.S. market is absolutely crucial to building a diversified portfolio. Even with a rough stretch here and there, a portfolio would easily be incomplete without U.S. large cap exposure. But in many investors’ minds, the same can’t be said for emerging markets. I would argue, however, that this line of thinking is incorrect, at least if you consider how massive emerging markets have become and how vital they are to the global growth story.
Importance of emerging markets
The surging importance of emerging markets can be shown by with a single chart. Below, emerging markets as a share of world GDP are shown vs. the same measurement for the U.S. market over the past 60 years.
*Gross domestic product (GDP) as defined by current prices. GDP based on purchasing power parity (PPP) would put EM & developing economies (as defined by the International Monetary Fund (IMF)) at 59% of world vs. 15% for the U.S. Source: IMF as of October 2018 (latest available).
As displayed, emerging markets were roughly half as big as the U.S. economy in 1960, but they have slowly been increasingly their relative size over the past three decades. One might be forgiven for avoiding emerging markets when the space was less than a fifth of global GDP and easily dwarfed by U.S. markets, but those days are long gone.
Roughly since the financial crisis, emerging markets have been a bigger portion of the global economy than the United States. And based on the trend above as well as the strong growth rates seen in a number of emerging markets—the IMF has developing nations easily outpacing global average growth rates—this doesn’t appear to be a situation that looks to turn around anytime soon.
Emerging Markets Impact
The chart above and the trend line showcase that emerging markets are too big to ignore any more. Investors may no longer be able to get by with limited-to-no emerging markets exposure, as writing off nearly two-fifths of the globe’s economic output seems likely to produce an inadequate portfolio at best, and one without many of the world’s key economic drivers at worst.
It is arguable that few understand just how vital emerging markets are to the world economy at this point, or how easily they overshadow American economic output. That seems to be the only reason that makes sense for investors shunning emerging markets, as a single year of sluggishness—following a two-year stretch of solid performance relative to the U.S.—doesn’t appear to be a rational motivation to give up on 40% of the global economy.
One of the most important items to keep in mind for market allocations is that few would claim that avoiding the U.S. market would result in a complete portfolio; the American economy is simply too massive. Consider that next time someone wants to skip a market that is roughly double the economic size of the United States.