Emerging markets still offer diversification benefits

Correlations with Canadian equities have increased, but emerging markets still face different fundamentals and risk factors.

Patricia Oey 11 June, 2014 | 6:00PM

Emerging markets seem to have lost their lustre. The larger countries such as China, India and Russia are experiencing slowing economic growth. The commodity-oriented countries, particularly the ones in Latin America, are adjusting to a new normal after tailwinds from a decade of rising commodity prices have ebbed. Market returns in emerging markets have also moderated since the years leading up to the 2008 global financial crisis. From 2003 to 2007, the MSCI Emerging Markets Index (in Canadian dollars) posted an annualized return of 25%. Over the last three years, that return has fallen to a mere 1%.

There is also a perception that correlations across asset classes are higher relative to about a decade ago. This was clear in 2008 when almost all major equity markets around the world fell sharply. One reason for rising correlations has been globalization, where many of the largest firms in Europe and the United States -- such as   HSBC  HSBC and   Citigroup  C, and   GlaxoSmithKline  GSK and   Merck  MRK -- are actually more similar than different as they compete with each other across the globe.

Another reason has been the liberalization of capital markets in developing countries, which has resulted in greater foreign investor participation in local equity and debt markets. With greater foreign participation, these developing countries are now more susceptible to volatility originating in the developed markets. For example, in the summer of 2013, after the U.S. Federal Reserve indicated that it would begin to scale back its asset purchase program, countries with weaker economic fundamentals, such as Indonesia, India and Thailand, saw declines of around 20% (in U.S. dollar terms, from June through August) due in large part to heavy foreign fund outflows. In the few years prior to 2013, these markets had been relative outperformers and had seen strong foreign fund inflows.

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Patricia Oey

Patricia Oey  Patricia Oey is a senior manager research analyst for Morningstar.