There are many similarities between emerging markets today and the EAFE markets in the early 1980s. These similarities exist in four areas: perception, capitalizations, performance and correlations.
Throughout the United States in the early 1980s, international investing was a tough sell. There were many reasons, several of which derived from the afterglow of America's unassailable global dominance after World War II. There were objections to investing in Japan because many senior captains of industry had fought in the Pacific, and objections to investing in Germany for similar reasons. Britain was described by one consultant as a "Historical Theme Park." Despite a growing admiration for Mrs. Thatcher and its victory in the Falklands, Britain was regarded as a political and economic has-been of little relevance to the United States.
France and Italy were nice tourist destinations, but hardly countries to which pension assets might be entrusted. Smaller European nations, like Belgium or Norway, did not feature in the thoughts of most Americans. Southeast Asia still carried the stigma of Vietnam, while Hong Kong was perceived as having inordinate risk because of the hand-over to China in 1997. Australia and Canada enjoyed a certain popularity among U.S. investors in the late 1970s because of their mining and natural resource companies, but South Africa was politically unacceptable.
International investing generally connoted high political risk, social unrest, communism, immature markets, illiquidity and poor accounting.
In addition to these negative views, the U.S. stock market was regarded as being a perfectly adequate home for pension assets. It represented over 70% of the world's market capitalization in the early 1970s and was considered safe and regulated. In short, investing internationally was largely considered as an unnecessary and risky fringe activity.
It is thus not surprising to hear identical objections to emerging markets today. The Morgan Stanley Capital International Europe Australasia Far East Index is widely regarded as an important component of pension assets today, whereas emerging markets are often seen as venture capital in exotic currencies. In 1994 there are a few foresighted pension funds allocating small amounts to emerging markets, as an offshoot of their EAFE activities. It is almost certain that a flood of money will be allocated there at the end of the 1990s after a period of spectacular, if volatile, performance. By then emerging markets will have "arrived," and won't, of course, be emerging any more. The pioneers of the industry will be into the next frontier of international investing. Who knows, it may be in African Reconstruction Bonds.
In December 1980, the total market capitalization of the Capital International World index was $2.291 trillion, of which the U.S. market represented $1.24 trillion, or 51.2% of the total. (In 1966, the United States represented 69.4% of the total.) At the end of 1993, the MSCI World Index capitalization was $11.896 trillion, of which the United States was $4.726 trillion, or 39.7% of the total.
The IFC Emerging Markets Global Index has only been in existence since the mid-1980s and by December 1993, was $825 billion. It represents about 6.5% of total world market capitalization. Some size statistics here are revealing. For example, the Mexican stock market today, at $124 billion, is the size of the German and French markets combined in 1980. Thailand's stock market, at $74 billion, is the size of Spain's, Sweden's and Switzerland's combined markets in 1980.
Admittedly, the investible portion of these markets is smaller for foreign investors, but the investibility of many mature markets can be tight too, such as in Germany or Japan.
The point is that some emerging markets are large enough to be fully fledged, but are regarded as emerging because they are not included on a mature-market index.
Performance statistics on EAFE markets are available to 1960.
In the 1960s, the U.S. market recorded a compound annual return of 3.99%. It was the seventh best performer, in U.S. dollars, out of 16 markets. The best was Spain, which returned 11.11%, followed by Australia with 6.45% and Japan with 5.55%.
In the 1970s, the U.S. market was 14th out of 18 markets. It recorded a compound annual return of 1.6% over the 10-year period. Hong Kong returned 21.26%; Singapore, 17.18%; Norway, 14.39%; and Japan, 14.03%.
During the 1980s, the Standard & Poor's 500 Stock Index had a compound annual return of 12.03%, and was 11th out of 20 markets. The top performers were Japan, 27.18%, and Sweden, 25.53%.
1993 was a banner year for EAFE investors with the index rising 32.6%, within which were some spectacular returns, from Hong Kong's 116.7% to Malaysia's 110%. Finland was up 77.7% in U.S. dollar terms. The U.S. was up a respectable, but dull, 9.1%, making its performance 22nd out of the 22 major stock markets.
Meanwhile, the emerging markets were blazing; in the five years ended 1993, eight markets rose more than 300%. Colombia was the leader with 618.6%, then Turkey, 559.9%, and the Philippines, 145.3%. Emerging markets have been showing performance that exceeded even that of the high-flying EAFE markets in the late 1970s, when compound annual returns of top markets like the United Kingdom were "only" 33.25% from 1975 to 1979.
A common objection to smaller markets is the volatility of returns. Some investors find it hard to handle a year in which their investment rises by 98%, followed by a year in which it falls 22%. After a 272.2% rise in 1993, Turkey experienced market wind-shear in early 1994, falling 67% before recovering to a 40% loss by May. The key with emerging markets, as in all investments, is diversification. While one component of the index is crashing to earth, there is a good chance another part is taking off, or at least stable. There are 18 countries in the IFC Investable Emerging Market Index, and an investor in emerging markets would be well-advised to invest as broadly across these markets as possible.
Correlation coefficients measure the extent to which markets move together. In the EAFE markets, correlations have been rising steadily since the 1970s. For example, from 1970 and 1974, average correlations with the S&P 500 were: Japan, 0.34; the U.K., 0.50; France, 0.38; and Germany, 0.32. Ten years later, they were: Japan, 0.61; U.K., 0.78; France, 0.8; and Germany, 0.49. In 1973, the EAFE Index had a correlation of 0.53 with the S&P 500. The correlation had risen to 0.73 in 1993. There are many reasons for this, one of which is that mature markets are linked electronically, information travels faster: In short, the markets are more "efficient," in the academic sense, than 20 years ago.
Emerging markets have low correlation coefficients with the S&P 500, with each other and with the EAFE Index. Given such risk-reduction potential, we should see a substantial and lasting allocation of U.S. pension assets into this asset class. The IFC Asian Index has a correlation of 0.35 with the S&P 500 and 0.2 with EAFE. The IFC Latin American Index has a correlation of 0.3 with the S&P and 0.26 with EAFE. Correlation between Argentina and Greece is 0.1; between Malaysia and Colombia, 0.01; and between Zimbabwe and Jordan, 0.12.
The lack of maturity or interlinking between these markets makes them an interesting destination for long-term funds. Correlations probably will rise over the next 20 years in emerging markets, just as they have in the EAFE markets, but there still are many inefficiencies to exploit before they mature to EAFE levels.
There are many parallels between emerging markets today and the EAFE markets 15 years ago. My main conclusion is that emerging markets are a huge, largely unexploited resource for U.S. investors that should provide above-average long-term opportunities. The current market sluggishness has seen substantial corrections in many emerging markets. I suggest it is better to sample this asset class at these levels rather than wait for the top of the next boom. In other words, think of emerging markets as you might have approached EAFE in 1984. It was a depressed and unloved market that recovered strongly over the next three years. Emerging markets may well be in the same limbo, as they consolidate before recovering later in the 1990s.
Gavin R. Dobson is chief executive at Blairlogie Capital Management, Edinburgh, Scotland.