Emerging Markets: Aguas Tormentosas or Rio Tranquilo?

2018 was a turbulent year for emerging markets (EM) investors. From its late January 2018 high to its October low, the emerging markets index ⁽¹⁾ fell 27% when measured in US dollars. This reinforces the belief that emerging markets are exceedingly risky – the aguas tormentosas (stormy waters) that the intrepid Spanish sailors in the 1500s feared when they set out on long voyages to the New World.

But the above “high to low” return exaggerates reality. For the full 2018 calendar year, the total return from emerging markets, when measured in Canadian dollars, was a loss of 7.1%… still a meaningful loss, but not nearly as bad as the high to low measure. In part, this was thanks to a strong start for EM in January 2018 and a recovery at the tail end of 2018. Also, the Canadian dollar (C$) weakened in 2018. This C$ weakness had the effect of improving the return from EM when measured in C$.

What caused the EM loss of 7.1% in C$? The usual explanations tend to be very general: trade tensions, increasing interest rates, investors seeking safe havens, and so on. However, it is instructive to dig a little deeper and divide the 2018 loss into its underlying component parts, as shown in the chart. Any equity market return can be broken down into the components attributable to the companies’ underlying performance (the two grey boxes on the left of the chart, that is dividends paid and corporate earnings growth) and the components attributable to the markets (the two green boxes in the chart, that is the valuation change and currency change). Let’s start with how the companies performed in their local currencies. For the year, these companies collectively paid a dividend of 2.4% and increased their earnings over the course of the year by 2.8%. A 2.8% rise in earnings isn’t great, but it was at least positive in a tough year. So far, so good – management of these companies “did their job”. Now we turn to investors (who collectively make up the market). With all the stormy waters, heightened investor fears resulted in the share prices of EM stocks declining 12.3% in their native currencies. To properly separate out the underlying causes, the share price decline has two components – the aforementioned 2.8% increase in earnings by the underlying companies and a decline in the EM price to earnings valuation multiple of 14.7% attributable to investors’ views changing, that together resulted in the 12.3% share price decline. ⁽²⁾ Finally, the weakening in the C$ improved the return by an additional 3.5%, resulting in the net total return loss of 7.1% in C$. So, the overall message becomes clear in the chart. In 2018, EM companies did what they are supposed to do – pay dividends and increase earnings. But the companies’ good performance was overwhelmed by market effects – the valuation decline and the currency effect – which turned out to be the two biggest drivers of the poor 2018 total return.

Rio Tranquilo

Over the longer term, a completely different picture of EM emerges. The second chart, which shows the annualized total return from EM over the 15-year period ended December 31, 2018, illustrates this. In the Rio Tranquilo, the waters appear tranquil, but there is nonetheless a powerful current in the river. The “current” is provided by the companies. The annual average return from dividends over the full 15 years was 3.1% per year and another 6.3% came from earnings growth. The “wild” short-term market effects (again, these are the valuation change and currency changes) became much smaller over long time periods. As the cycle of greed and fear repeats, up follows down and down follows up – forces that tend to cancel out over time. Over the full 15 years, the annualized valuation effect has been a tiny -0.2% per year and the overall currency effect shrank to a small -0.7%. This makes sense. There is little reason for a long-term change in the valuation multiple. Rather, the total return to the equity investor comes from companies doing what they do: paying dividends and growing earnings. Similarly, currencies go up and down in value against each other as short-term market forces and sentiment jostle them. Over the long term, however, the primary driver of the exchange rate of two currencies is simply the inflation rate differential between the two countries. ⁽³⁾ For the 24 emerging market countries as a whole, most, like Canada, have inflation under control, resulting in the relatively small currency effect.

Emerging markets look scary. But these countries develop over time and grow more quickly than developed markets. The actual companies in EM have also grown, exhibiting better stability and governance characteristics over time. Today, the average market capitalization of each company in the EM index is close to C$20 billion – not too shabby and bigger than many Canadian companies. Finally, EM companies collectively have a dividend yield of 2.8% and a forward valuation multiple of 11.7x, both more attractive than North American companies. So, the next time you look at EM, try and see the Rio Tranquilo rather than the Aguas Tormentosas.