Asset Allocation

The Changing Face of Emerging Markets

March 9, 2018
Timothy Murray explains why emerging markets are now a different animal from what they were and why this has implications for asset allocators.

Key Points

  • Emerging markets have evolved, and investors now need to look at them through a different lens.
  • Infrastructure-driven sectors have become much less important drivers of performance, while consumer-oriented sectors have dramatically increased in importance.
  • For tactical asset allocation purposes, the outlook for commodity prices is still quite important to the relative performance of emerging markets equities, but it is now part of a much broader mosaic of factors.
  • Partially due to the ongoing trend toward more domestically driven economies, emerging market fundamentals are becoming more impacted by country-specific factors, making broad generalizations about the asset class more and more difficult.
  • This makes evaluation more complex for tactical asset allocation purposes, but it also means that the alpha potential for active management is higher.

Emerging markets (EMs) are a different animal from what they were 10, or even five, years ago. The term “emerging markets” is now more a matter of benchmark classification as opposed to some common fundamental factor. While perhaps sounding like a subtle distinction, the importance is both high and far-reaching for investors, from both a bottom-up stock-picking perspective, as well as from a tactical asset allocation perspective.


Emerging economies, led by China, are the most important engine of incremental global economic growth. The dynamics of their economies, their growing share of world trade, and their increasing importance in global equity markets are trends of fundamental and long-term significance. According to projections by the International Monetary Fund (IMF) released in October 2017, emerging and developing economies will be responsible for 58% of all gross domestic product (GDP) growth over the next five years, with China alone responsible for 27%. By comparison, the United States is expected to be responsible for 17%.

Add to that the longer-term social aspects like urbanization and dramatically more attractive demographics than developed markets and it is easy to see why, conceptually, emerging markets equities seem as attractive an asset class as ever. Unfortunately, this attractive growth profile has not always translated into superior performance results—and in recent years, we have seen some important shifts in the dynamics of when and why emerging markets have outperformed (and underperformed) other regions. recent years, we have seen some important shifts in the dynamics of when and why emerging markets have outperformed (and underperformed) other regions.

In the late 1990s and early 2000s, EM equities delivered outsized returns relative to developed markets (Figure 1). During this period, many EM economies were boosted by China’s double-digit growth pace and massive investment in resources, leading to what was termed a “commodity supercycle.” This resulted in a virtuous cycle that benefited EM countries broadly—and several large countries in particular, such as Brazil, South Africa, and Russia, where natural resources are plentiful. It also meant that performance was heavily influenced by the direction of commodity prices.

However, as China began its transition to a more consumer-led economy, that powerful tailwind of rising commodity prices dissipated, and with it came a period of underperformance by EM equities (Figure 1). This caused much angst among investors as they tried to assimilate what had happened to the EM thesis. Were the unique qualities of emerging markets (i.e., superior economic growth and demographic advantages) enough to outweigh the cyclical exposure these markets held? Or had the experience of the 2000s proven they were simply an alternative way to increase exposure to commodity prices and other cyclically driven elements of the global economy? Recent evidence points to the former rather than the latter.


A look back over the last three years reveals that the relationship between commodity prices and EM equities has weakened significantly. EM equities had moved almost in lock step with energy prices from 2005 to mid-2014, but from 2014, they have moved much more independently (Figure 2A). This raises two questions: (1) Why did this relationship weaken and (2) Should we expect this to continue?

FIGURE 2B: MSCI EM Correlation to CRB Spot Commodity Price Index
Five-Year Rolling, in USD, as of September 30, 2017

Sources: MSCI and Credit Suisse research.

A key factor in the change has been the sector composition of the MSCI Emerging Markets Index, where there has been a marked shift away from commodity and manufacturing areas into consumer-driven ones. Most notable is the growth of the information technology sector, while energy and materials sector weights have fallen dramatically.

Since 2012, the IT sector’s size within the MSCI Emerging Markets Index has doubled to almost 28% of the index (Figure 3). That’s bigger than the technology weighting in the S&P 500 Index at around 24%.1 Importantly, much of the change has been driven by digital companies (i.e., “new tech”).

At the same time, the constituent weighting of the energy sector has almost halved, while the materials weighting has fallen to single-digit levels within the index. Elsewhere, index sector weights have evolved less dramatically, but in a similarly thematic fashion. Those sectors in infrastructure-driven areas of the economy—industrials, utilities, and telecommunications—have trended lower. Meanwhile, the sectors driven by domestic consumption—consumer discretionary, health care, and financials—have trended higher.


In addition to falling representation within the index, the performance of commodity areas has also been poor during the current cycle (Figure 4). As we have witnessed the slowdown in the demand for resources, we have seen sectors exposed to this trend underperform the wider market. Meanwhile, consumption areas have provided relatively strong performance, led by the technology sector. This dynamic has exacerbated the ongoing decrease in correlation between commodity prices and EM equities, as not only have energy and materials become smaller constituents, but returns for the sectors have been negative, while the majority of the benchmark has performed positively, particularly the technology sector.


These trends in benchmark composition are unlikely to reverse anytime soon given the ongoing wealth creation and the organic rise in demand within local economies over time. Economists have long predicted that rising emerging markets incomes would propel a shift from export-led to consumption-led growth, and this shift is well underway across most areas of the advancing world. The rising middle class consumption story (Figure 5) shows few signs of stalling, with China alone having lifted more than 600 million people out of poverty over the past three decades.  

China’s industrialization phase is clearly and intentionally fading, and as the economy has shifted away from an infrastructure and fixed asset investment-led growth model, the consumption and the services sectors have generally picked up the slack. When looking at the data, we see clear evidence of this change, with services as a percentage of GDP growing (Figure 6).

At the same time, more subdued economic growth in the developed world continues to erode the secular export theme within the whole of the emerging world. This leads us to suspect that EM fundamentals have evolved, and will continue to evolve, in a more self-reliant direction over time. China’s economy will not be the only one migrating toward a more consumption-oriented model.

An examination of the trade balance data shows that, indeed, many EM countries are seeing their trade balances narrow. Of the 10 largest emerging economies (based on GDP), the balance of trade for goods has narrowed over the last decade (Figure 7), except for Mexico. Net importers are generally importing less, while net exporters are also generally exporting less.


Partially due to this ongoing trend toward more domestically driven economies, emerging markets fundamentals are becoming more dispersed, making broad generalizations about the asset class more and more tenuous. You only need to look at performance on a country-by-country basis to see that they cannot be viewed under one singular homogenous banner anymore (Figure 8).

This is not a surprise to us given the ongoing economic and financial maturation within these countries. Few investors would group Japan, the UK, France, the U.S., and Australia together under a single banner, but since the emergence of emerging markets as an asset class 20 years ago, the fundamentals of India and Brazil have nonetheless been commonly associated with the fundamentals of the Philippines or Turkey, for example. However, the point of maximum fundamental correlation (remember the days of the BRICs ascending as one) was reached some time ago and has likely passed, leaving a more complex, and often confusing, situation in its wake.

A current view of sector weights further reveals the broad dichotomy of exposures by both country and region. Among the 10 largest countries by weight in the MSCI EM benchmark, information technology exposure ranges from over 60% (Taiwan) to 0% (South Africa, Russia, Mexico, Malaysia, and Indonesia). Meanwhile, energy weights range from 48% (Russia) to 0% (Mexico) (Figure 9). This dichotomy is also present on a regional basis, with information technology being the largest weight in Asia but barely represented in EMEA and Latin America (Figure 9).

Dispersion is also rising on a more granular level than just on a regional or country basis. An examination of rolling 90-day intra-stock correlation of the MSCI EM index shows that stock correlation has been gradually falling, after peaking in November 2008 (Figure 10). This means emerging markets stock movements have been gradually becoming more independent for almost nine years, insinuating that getting choices right at the stock level is becoming even more important.


From an asset allocation perspective, the rise in dispersion means that we need to adjust our assumptions about what environments will be most beneficial, while also recognizing that the experience of active investors in EMs may be markedly different for passive investors.

Falling oil prices may be a catalyst for poor performance within Brazil or Russia, but it may mean that consumers in China and India have more disposable income to spend on food, travel, or entertainment—areas that are now more heavily represented within EMs. Meanwhile, numerous country-specific variables, such as the actions of central bankers and politicians, cultural trends, demographics, and even weather within each country, can have considerably more impact on each individual domestic economy.

One implication of this increasing dispersion within the asset class is we should expect EM equities to have a more muted reaction to specific macro forces going forward and, therefore, moderate our conviction regarding tactical allocations to EMs based on specific macro factors. Another is that we should expect falling correlation among equities within the EM universe and, therefore, should expect underlying stock selection to have a greater effect on portfolio performance.

For asset allocators, this ongoing change in emerging markets represents both a challenge and an opportunity. The playbook for allocating to emerging markets equities used to be more cyclically driven. In a nutshell, it went something like: Do you think global growth will be healthy? Do you think commodity prices will be strong? Do you think emerging markets currencies will be strong? If the answer to all these questions was yes, then EM equities were very likely to outperform other regions. Now one has to concede that it is much more complicated. Macro factors like global growth, commodity prices, and currency markets are still quite important, but they are now part of a much broader mosaic of factors.

The opportunity lies in the recognition of two important realities: (1) Emerging markets may continue to offer stronger economic growth trajectories than developed markets and (2) Emerging markets now include a much greater representation of country-specific influences.

Point one argues for the need to have exposure to EMs in portfolios with long time horizons, while point two argues for the need to gain this exposure through an active manager that is well equipped to identify the best opportunities within emerging markets.

1Information technology weighting in the S&P 500 Index was 23.8% as of December 31, 2017.

Important Information

This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.

The views contained herein are those of the authors as of February and are subject to change without notice; these views may differ from those of other T. Rowe Price associates.

MSCI makes no express or implied warranties or representations and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed, or produced by MSCI.

This information is not intended to reflect a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell any securities or investment services. The opinions and commentary provided do not take into account the investment objectives or financial situation of any particular investor or class of investor. Investors will need to consider their own circumstances before making an investment decision.

Information contained herein is based upon sources we consider to be reliable; we do not, however, guarantee its accuracy.

Past performance cannot guarantee future results. All investments are subject to market risk, including the possible loss of principal. International investments can be riskier than U.S. investments due to the adverse effects of currency exchange rates, differences in market structure and liquidity, as well as specific country, regional, and economic developments. These risks are generally greater for investments in emerging markets. All charts and tables are shown for illustrative purposes only.

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