MSCI's decision to include Chinese A shares in its emerging market benchmark equity index is a watershed moment.
To be sure, this move is helping to expand the investible universe and is a step in the right direction toward making the index more reflective of the emerging markets' true economic potential. Yet, as investors evaluate the implications for their portfolios and the best ways to capitalize on this development, they would be wise to reflect on their approach to emerging market investing more broadly, understanding the best investment opportunities will be driven more by the structural forces shaping emerging markets today than by changes to the indexes. Even with this announcement by MSCI, passive strategies will be insufficient in the new economic order. A bottom-up approach that focuses on the cross-cutting themes, sectors and companies that drive investment returns in emerging markets will be required.
Coined in 1981, the term "emerging markets" was meant to capture the dynamism of a third world that hitherto had conjured images of drought-ridden farmlands, knock-off electronics and Soviet-era machinery. For several decades, sensible market reforms, trade liberalization in the West and export-led growth helped emerging markets fulfill this economic promise. That era is over.
For a start, aging populations have structurally constrained the long-term growth potential of developed markets to well under 2%, stifling demand for exports from emerging markets. In parallel, rising emerging market wages and increasing automation are beginning to shift some manufacturing sectors back to developed markets, especially as Western firms weigh the sociopolitical advantages of a homemade product.
On top of that, growing income and job polarization in the United States and Europe has led the middle classes of developed countries to stage a populist backlash against globalization and free trade. It is striking that while income inequality between countries around the world has steadily declined since the 1980s, inequality within individual developed economies has actually increased over the same period, leaving developed market workers feeling disempowered, vulnerable and at the losing end of globalization. The resulting protectionist sentiments are threatening to unravel a global trade regime that significantly benefited emerging markets.
In short, the rising developed market tide that lifted all emerging market boats is rapidly receding. Increasingly, emerging markets are masters of their own fate, with their individual abilities to capture domestic and regional opportunities determining their future growth paths. But if emerging markets can no longer ride on the coattails of developed market growth, global trade liberalization or Chinese supply chains, will they still have a role to play in driving global growth?
The answer is unequivocally yes. As developed market economies slow down, retreat and offer savers increasingly lower yields, emerging markets will be the primary drivers of global growth over the next decade. They already represent nearly 60% of global gross domestic product on a purchasing power parity basis and are forecast to contribute over 90% of global middle-class spending growth between now and 2030.