Emerging Is Perturbing

Emerging market stocks have underperformed U.S. stocks for a decade. This is despite expectations for the opposite given the higher risk and greater volatility. Is the turning point near? How does the performance of emerging markets relative to U.S. large cap stocks compare to U.S. value and small cap stocks?

Measurement Minutiae

Launched in 1988, the MSCI Emerging Markets Index (EM) captures over 1,400 large and mid cap stocks across 26 emerging market countries. The largest country weights are China at 39%, followed by Taiwan and South Korea at 12% each. The largest sector weights are Financials at 20% and Information Technology at 17%. The index represents about 13% of all global equity market capitalization. For long term relative performance comparisons I use the Russell 1000 index for larger U.S. stocks, the Russell 2000 Index for small cap stocks, and data from Fama and French[1] for value stocks.

Long Term Lethargy

Chart 1 plots the ratio of the total return of the EM Index to the total return of the Russell 1000 Index. The grey bars show all recessionary periods. When the ratio line is going up EM is outperforming the Russell 1000, and underperforming when it is going down. As you can see, EM has dramatically underperformed the Russell 1000 for the last 10 years. Since the last peak in relative performance in September 2010, EM provided a paltry annualized return of 1% versus 13% for the Russell 1000. Over the entire 32-year history, EM underperformed as well with an annualized return of 5.2% versus 10.6% for the Russell 1000.

Chart 1

Source: MSCI, FTSE Russell, Morningstar, National Bureau of Economic Research

Recession Progression

There have only been 3 recessions prior to 2020 since the EM data started. In all of them EM underperformed for the first few months before outperforming for a few years as shown by the green up arrows in Chart 1. So far in the 2020 recession EM has underperformed in the 4 months since the official start in February.

Relative Relationships

Previously I have highlighted the cheapness of value stocks and in my last blog small capitalization stocks. So how do they compare to EM? In Chart 2 I looked at how they each performed versus the Russell 1000 and found four important takeaways. The first is that the relative performance of EM is much more volatile. EM is three times more volatile than value stocks and five times more volatile than small cap stocks. The second is that EM, value, and small cap all reached their cheapest level to the Russell 1000 during the tech bubble years. The third takeaway is that all three have been underperforming for many years now. The final takeaway is that EM had the most relative performance upside during outperformance trends.

Chart 2

Source: MSCI, FTSE Russell, Morningstar, Fama/French

The Way Today

Looking at year-to-date returns to June 23 of EM, value and small cap versus the Russell 1000 index of larger cap U.S. stocks, EM has been the best of the worst[2]. The Russell 1000 returned -2%, EM -9%, small cap -13% and value -15%. Looking forward, in the first phase of moving from recession to recovery value is likely to outperform as countries, markets and companies adjust and adapt to a pandemic affected world. Over the longer run however, EM can provide a bigger upside performance although it will be more volatile.

Invest Wisely,

Dave Schaffner, CFA

Principal, Wayfairer Capital Management Ltd.