A Macro Perspective on Investing in Emerging Markets

The Macro Affairs Portfolio Invests Heavily in Emerging Markets.

Map with emerging markets
Emerging Markets in MSCI Index

If you buy a regular, market-cap-weighted all-country index fund, then just 12% of your portfolio is invested in emerging markets. But Macro Affairs nearly quadruples this baseline exposure to emerging markets to 45% of the portfolio – this is considered an over-weight position in emerging markets.

There are two reasons why we are heavily invested in emerging markets. The first is that there are serious structural problems in the developed markets, and the second is that the fundamentals and long-term prospects of emerging markets are better than ever before. At the end of the article you will find some practical ideas on how best to invest in emerging markets.

Problems in Developed Markets

The two main developed markets are the U.S. and Europe. Their issues are their monetary and social systems. These two markets show an interesting contrast: what the one gets right, the other gets wrong.

The U.S. has a good monetary system. The U.S. central bank has a mandate that includes targeting inflation, low unemployment, and financial stability. The U.S. federal government spends about 20% of GDP, which is a huge re-distribution of wealth from the rich states to the economically weaker states.

But in Europe, the common currency threatens the future of Europe. The European central bank’s only mandate is price stability, and there is no Euro-zone wide deposit insurance or stability mechanism. On top of that, the European Union spends about 1% of GDP, which means that the EU has almost no redistribution powers to create convergence within the block and correct for the monetary deficiencies. The current design of the Euro zone is such that countries’ prosperity will diverge over time – leading to financial and political crises. This has been a known problem for 20 years already, and no effective measures are in the pipeline.

While the U.S. may have a great monetary system, its internal social system has always been weak. Wealth inequality in the U.S. in particular has been increasing, which slows economic growth. The U.S. leads other western countries in obesity, incarceration rates, and homicide (no source needed for these). U.S. citizens also underestimate their comparatively low social mobility. U.S. politicians continuously fail to effectively address these social problems, which suggests that the negative effects of these social problems will continue to lower the economic development and outlook for the United States for the foreseeable future.

Although Europe is far from having completed the ‘socialist dream’, European governments are still spending relatively more on education and pensions, keep up sustainable labor laws and a living minimum wage, and have cheaper healthcare systems that provide better median-quality healthcare.

Finally, both Europe and the U.S., as well as other developed countries (e.g., Japan, Australia), are now home to an aging population. This aging population is an economic concern for developed markets because a smaller portion of the population will be economically productive and the public debt burden stops being shared with ever-more people. Although China also has an aging population, this is less of an issue in emerging markets generally.

Emerging Markets Outlook

While emerging markets only make up about 12% of the stock market world wide, their nominal GDP makes up 40% of world GDP, and their GDP based on Purchasing Power Parity (PPP) is already at 60%. This means that the emerging economies together can already purchase more than developed economies in 2018.

Global Stock MarketGDP (nominal)GDP (PPP)
Developed Markets88%59.3%40.7%
Emerging Markets12%40.7%59.3%
Source: IMF

Emerging Economies are Serious About Investing in their Economic Future

The large purchasing power of emerging markets is not merely squandered on European luxury goods. Investments in emerging markets are stimulating their economy to the point where emerging markets are the driver of global economic growth. Emerging economies invest mostly in education and infrastructure.

Already China has 4 times more high-speed rail than the U.S., and they have been doubling their rail capacity every 5 years. China is able to do this because they still have low wages for laborers, lots of engineers, and the government doesn’t need permission from land owners or cities to start building. These rail networks are a tremendous economic advantage that cannot be replicated easily by developed countries.

The Chinese railroads and massive ports also feed into the belt and road initiative. This initiative will create transport links throughout Asia and the middle east to make the region more interconnected. China’s land-locked West will be opened up with a corridor to the sea that runs through Pakistan – which will help China’s West export and develop economically. The belt and road initiative will not only help China’s trade but also the rest of the region.

Besides the belt and road initiative, China also founded the Asian Infrastructure Investment Bank (AIIB) for Asian countries and the New Development Bank (NDB) for the BRICS countries (Brazil, Russia, India, China, South Africa) as alternatives to the U.S.-led World Bank where China was not allowed to participate enough. While loans from the World Bank came with conditions about human rights and environmental responsibility, the new, China-led investment banks make loans with no strings attached.

The U.S. has been the world’s economic and military superpower for the past 70 or so years. The U.S. navy had control over all seas, including the South China Sea. But this is changing as China is becoming the world’s superpower and China will get to enjoy its superpower privileges.

The worries about high levels of Chinese or other emerging market debt are exaggerated. Emerging market debt is mostly denominated in local currencies (which they can print more of) and total debt levels are lower than in the West. Emerging markets still lag behind in warfare capabilities, although they are catching up. Short of war, it seems like nothing will be able to stop the rapid economic development of emerging markets.

Overweight Emerging Markets

Emerging markets are trading at a lower price-to-earnings ratio than developed markets. At the same time, they are growing a lot faster. This strange combination will result in emerging markets greatly outperforming developed markets over the coming 10 years. The Macro Affairs portfolio heavily over-weights emerging markets.

China lies at the center of the development and power of emerging markets. Macro Affairs puts half of emerging market assets in China and the other half in other emerging markets. Macro Affairs does this using broad-market index funds that track the MSCI Emerging Markets Investable Market Index and the MSCI China Index.

For more macro perspective on emerging markets, check out our article on why we think that South Korea, Hong Kong, and Israel should still be considered emerging markets.

What is your perspective on investing in emerging markets? Do you have an over-sized allocation to emerging markets? Let us know by leaving a comment below!

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