Emerging market (EM) stocks were once seen as essential components of a diverse investment portfolio — that is until many of them started to come up well short of expectations over the past few years. But equity markets in the developing world should not be forgotten, says Kurt Reiman, chief investment strategist for BlackRock Canada, and may provide important long-term diversification opportunities, some of which may be a surprise to Canadian investors.

“Emerging markets have the advantage of low debt, growing incomes and a relatively young population with pent-up consumer demand,” says Reiman. “Developed markets are richer, but also older, more indebted and less vigorous. If markets were people, there’s little doubt which one investors would rather date.”

Despite these advantages, Reiman notes that emerging markets have generally underperformed developed markets since 2011. Blame that on a number of factors, ranging from falling commodity prices to heightened political risk, kneecapped economic growth, government corruption, stalled reform agendas and limited earnings growth.

Determining the underlying value of EM equities has also been difficult for Canadian investors because movement in both EM equity markets and currencies have mirrored those of Canada.

That’s because EM stocks, bonds and currencies also react to many of the same signals: commodity prices, interest rate decisions made by the U.S. Federal Reserve, and changing prospects for the world economy, China in particular. Since 2005, Canadian equities have been much more positively correlated to EM equities than to U.S. or other international developed stock markets as represented by MSCI EAFE index.

That same synchronicity has also eroded the benefits of diversifying into EM equities for Canadian investors.

“However, since the markets hit their January lows, emerging market stocks have been delivering sizable returns in U.S. dollars,” says Reiman. “Those advantages have been masked to Canadian investors, because of the rising strength of the loonie. If there’s any stabilization in commodity prices and global economic activity over the balance of this year, I think you’ll see an outsized response from EM currencies over the loonie, and that could be a source of return for Canadian investors.”

And while EM economies aren’t monolithic, they’ve historically reflected either a similar sectoral dependence on resources, or sensitivity to commodity prices. That’s changing.

“It isn’t on a lot of people’s radars, but technology has taken on a much larger share of emerging market indexes, whether it’s Internet or leap-frogging bricks-and-mortar businesses, or the infrastructure needed to support the cloud,” Reiman says.

“After five years of underperformance, emerging markets are probably under-represented in Canadian client portfolios. While we’re no means bullish on emerging markets, we’re now warming up to the diversification benefit of EMs from both a currency and sectoral perspective.”

It’s not a short-term narrative.

“Things have slowed down everywhere, post-financial crisis,” says Reiman.
“Wherever you look in the developed world, it seems like economists are lowering even lowered expectations. Looking forward to the later years of the decade, the developed world will probably struggle to maintain annual growth rates of two per cent, while EMs are looking closer to five.”

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The opinions expressed are as of December 2015 and may change as subsequent conditions vary. The information and opinions contained in this post are derived from proprietary and nonproprietary sources deemed by BlackRock to be reliable, are not necessarily all-inclusive and are not guaranteed as to accuracy. As such, no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BlackRock, its officers, employees or agents. This post may contain “forward-looking” information that is not purely historical in nature. Such information may include, among other things, projections and forecasts. There is no guarantee that any forecasts made will come to pass. Reliance upon information in this post is at the sole discretion of the reader.

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