Pondering Emerging Market Equity Allocations

The latest economic news from China suggests that the world’s second-largest economy is stabilizing. As Reuters reports, “factory output rose 9.7 percent in July from a year earlier, the fastest growth since output grew 9.9 percent over January and February, National Bureau of Statistics data showed.” Is this a clue for thinking that that the topical news of late that emerging markets are destined for a “Great Deceleration” is premature, timely, or ancient history?

China isn’t the only emerging market, of course, but it’s a big piece of this pie. Perhaps the better question: Should we be surprised that China’s economy appears to be stabilizing? As usual, the answer depends on the analyst. Neil Shearing, chief emerging markets economist at Capital Economics, recently advised clients in a research note (August 1) that the Great Deceleration is old news. Based on his figures, emerging market “growth peaked in 2010 and has slowed pretty much in a straight line ever since. Our proprietary GDP Tracker suggests that the emerging world is now growing at an annual rate of around 4%–down from a high of 9% in the second quarter of 2010.”
The market has already priced in this slowdown, or so it appears. The iShares MSCI Emerging Markets (EEM) ETF, for instance, is more or less flat for the past five years. By comparison, US equities (SPDR S&P 500 (SPY)) are up by nearly 8% over the last five years on an annualized total return basis; foreign stocks in developed markets are higher by around 2% a year (Vanguard FTSE Developed Markets ETF (VEA)), through August 8, 2013.
The past, as always, is clear, but what does all this say about the future? Shearing advises that “the bulk of the slowdown [for emerging markets] may already have happened.” He expects slower growth in China, though, an outlook that finds support in the July update of the HSBC China Purchasing Managers’ Index, which slipped to an eleven-month low at 47.7, or well below the neutral 50.0 mark. Nonetheless, he reminds that performance in the emerging market realm will vary and that “growth in some parts of the emerging world is likely to accelerate in 2014-15, even as the BRICS [Brazil, Russia, India, China] remain weak.” In sum, “the big adjustment from double-digit rates of expansion to growth of 6-7% has already taken place,” he asserts.
What does this imply for asset allocation? Mr. Market’s weight for emerging market stocks is currently 9.6% of the global equity pie, according to S&P Global BMI data. Not surprisingly, the trend is down this year, from around 11.6% at the close of 2012. If you’re still bearish on emerging markets, a below-market-weight allocation looks reasonable… assuming you’re right, which implies that Mr. Market’s 9.6% weight is wrong.
The market may very well be wrong… it wouldn’t be the first time. But in the grand scheme of allocations, there’s a fair amount of randomness in terms of ranking, ex post, the right and wrong allocation choices across a wide spectrum of portfolios. Meanwhile, if you’re diversified across all the major asset classes, you’re not betting the farm that a single weight for one slice of your portfolio must be optimal. If you have a high confidence that Mr. Market’s wrong, by all means: change the weight. The greater your confidence that the market’s wrong, the bigger the gap between the weight in your portfolio vs. the market weight.
All the usual caveats apply, however, including the case for thinking that boring and broadly diversified asset allocations that hug Mr. Market’s weights tend to be competitive over medium- and long-term horizons. It could be different this time; you could be one of the handful of skilled (lucky?) investors who beats the crowd. But the cost of shooting for the 90% percentile of performance vs. a lesser realm of above-average results (where Mr. Market’s allocation tends to reside) is, well, challenging. All the more so if you plan to hold multiple asset classes, as you should.
What are your chances of beating the odds implied by history? Let’s put it this way: the fact that everyone’s now talking about the Great Deceleration in growth several years after it started isn’t encouraging.