An allocation to Emerging Markets is more than just a “nice-to-have” and deserves a two-digit allocation.
What Is the Right Portfolio Allocation for Emerging Markets?
While some advisors still recommend an emerging markets (EM) allocation in the low single digits, others have raised their allocation to as high as 20% in recognition of EM’s increasing maturity and opportunities.1 Who will be on the losing side?
EM’s growth historically has been fueled by exporting raw materials, commoditized goods and infrastructure development. Now its middle class, more than 2.2 billion strong,2 is driving GDP through its consumption of EM’s goods and services in a new stage of economic development. Moreover, innovation in EM is creating new companies and technologies that represent compelling investment opportunities.
A Bit of History on Emerging Markets
From the 1980s until the mid-1990s, growth in emerging markets was largely driven by an export-oriented fixed asset model that pre-dated the heavy globalization of the past 25 years, and in this way, EM economies were less integrated with the sophisticated sectors of developed markets.
In the second phase of EM development, from the late 1990s through the mid-2010s, growth became more interdependent with advanced economies. Deeper integration of supply chains fueled more sophisticated exports, such as OEM manufacturing of technology components. GDP growth was further supported by higher commodity prices and additional infrastructure investment.
Current Landscape of Emerging Markets
The size of the middle class in emerging economies could register annual growth rates of 6% or more per year,3 while in developed economies, it has matured and is projected to grow at only 0.5% to 1% per year.
The MSCI EM Index has also changed: consumer discretionary and information technology are now the largest sectors versus in 2007, when the biggest sectors were energy, materials and industrials,4 now ranked 5th, 6th and 8th, respectively, in the index.5
Asian countries, several of which lead in tech innovation, make up about 72% of the index overall, while the weights of Brazil and Russia have shrunk to less than 8% and 4%, respectively, from 18.91% in 1988 and 5.70% in 1997.6 By 2040, Asia could account for more than half of global GDP and about 40 percent of global consumption.7
Number (Millions) and Share of the Global Middle Class by Region
Source: Thornburg analysis of Wolfensohn Center, Brookings Institute data from “The New Global Middle Class: A Cross-Over from West to East” by Homi Kharas and Geoffrey Gertz, updated and republished in February 2017 by Homi Kharas The Unprecedented Expansion of the Global Middle Class: An Update
Emerging Markets Innovation in Products and Services
Innovation in many emerging market economies is moving rapidly and independently from developed markets in multiple sectors, such as technology, entertainment, health care and financial services.
Capital flows can reveal where innovation is taking root. Asia’s share of global start-up funding increased from 16% in 2013 to 47% in 2018. About 70% of venture capital funding in Asia is intra-regional, making the continent less dependent on capital from developed economies.8 The region’s share of patents filed worldwide in 2017 was 65%, up from 52% a decade before.9
Innovations often lead to growth in consumption at home and in exports. For example, e-payment systems developed in China now handle $25.1 trillion in annual transactions10 and account for 42% of the world’s e-commerce transactions.11 Other examples of EM innovations are super high-speed trains and even 3D printing of living tissue for medical use.12
Volatility Differential between Emerging Markets vs Developed Markets
Along with these advancements, the volatility differential between EM and developed market equities has narrowed in the last decade.
Emerging markets are coming of age and investors may want to consider a two-digit allocation going forward. Still worrying about volatility? Give some thought to actively managed EM funds with a lower beta and balanced portfolio construction.