Westaway citywire emerging markets.pptx final screen

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The role of emerging markets in diversified portfolios Peter Westaway Chief Economist and Head of Investment Strategy Group, Europe Vanguard

Citywire Wealth Management Retreat The Grove, October 2013

2

Market performance

• EM equities traditionally outperform DMs over the long run, but they can underperform for long periods

• Unwind of QE may harm EMs, but some fallback already priced in

Economic performance

• EM economies look set to continue to make a major contribution to world growth.....and within that, China will be very significant

• Prospects for EM economies look promising but risks abound (domestic and global issues, ie Fed policy, sovereign crisis, China slowdown)

Investment considerations for EMs

• Correlation between EM equity returns and EM growth is weak

• Contrary to popular belief, Ems are not a thin market where smart investors can make easy money

Key point: EM equities have an important role in diversified equity portfolios

Outline of presentation

3

Investor interest in EM surged since the financial crisis

Trailing 3-year flows in emerging equity products across the world

-30

-20

-10

0

10

20

30

40

50

60

70

1995 2000 2005 2010

Avera

ge a

nnual flow

over

36

-month

rolli

ng p

eriods

(US

D b

illio

ns)

Notes: Morningstar asset flows into US Open-end & EFT excluding Money Market funds, excluding Fund of Funds, Excluding Obsolete Funds and Diversified World Stock

Source: Vanguard, based on data from the Morningstar. Data as of 13 September 2013.

4

Source: Vanguard Investment Strategy Group based on MSCI. Data presented is as of 17 September 2013.

EM equities have typically outperformed DM... but with more volatility

Yearly percent change in total returns of developed and emerging market equities

-80%

-60%

-40%

-20%

0%

20%

40%

60%

80%

100%

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Year-

on-y

ear

gro

wth

Developed Markets Emerging Markets

5

EM equities have typically outperformed DM... but with more volatility

Difference in yearly percent change in total returns of DM and EM equities

-0.8

-0.6

-0.4

-0.2

0

0.2

0.4

0.6

0.8

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012

Source: Vanguard Investment Strategy Group based on MSCI. Data presented is as of 17 September 2013.

6

EMs have outperformed DMs on average since 1990 but not systematically… recent performance has been lacklustre

Emerging markets - developed markets relative return (Jan 1990=100)

0

50

100

150

200

250

1990 1995 2000 2005 2010

Em

erg

ing M

ark

ets

-Develo

ped M

ark

ets

rela

tive

retu

rn (

Jan 1

990=

100)

Source: Vanguard Investment Strategy Group based on MSCI. Data presented is as of September 17, 2013. For additional details, see Vanguard white paper, Investing in emerging markets: Evaluating the allure of rapid economic growth, April 2010.

7

Emerging market valuations are now similar to those in developed market benchmarks

12-month trailing price to earnings ratio: Developed markets versus emerging

0

5

10

15

20

25

30

35

40

45

1995 1997 1999 2001 2003 2005 2007 2009 2011

MSCI Emerging Markets Index MSCI World Index

Emerging market valuations were not

as elevated as developed markets in

the early 2000's

Today, valuations

are more similar

Source: Vanguard Investment Strategy Group based on MSCI. Data presented is as of September 17, 2013. For additional details, see Vanguard white paper, Investing in emerging markets: Evaluating the allure of rapid economic growth, April 2010.

8

Risky bond segments (e.g. EM) had returned to pre-crisis yields …but recent Fed-related worries caused yields to rise again

0

5

10

15

20

25

2007 2008 2009 2010 2011 2012 2013

Yie

ld

Global Inv-Grade Corporates Global High Yield Corporates Emerging Market Debt

Source: Barclays as of 30 September 2013.

Notes: Global Investment Grade Corporates defined as the Barclays Global Aggregate Corporate Index, Global high Yield Corporates

defined as the Barclays Global High Yield Corporate Index, and Emerging Debt Defined as the Barclays EM USD Aggregate.

9

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

1980 1985 1990 1995 2000 2005 2010 2015 Share

of

Glo

bal O

utp

ut

of

DM

and E

M e

conom

ies


EM economies are gradually taking a larger share of world GDP

Share of world GDP, 1980-2012, and forecast through 2018

Notes: Displays each region's share of global GDP, in nominal US dollar terms.

Source: Vanguard, based on data from the IMF April 2013 World Economic Outlook Database

10

The global economy is still relying on emerging markets to drive growth

Contribution to global real GDP growth, by market

0.0

0.5

1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

5.0

1980s 1990s 2000s 2010-2013 Next 5 Years

Glo

bal R

eal G

DP

Gro

wth

U.S. Developed Markets (ex U.S.) Emerging Markets

Notes: Each region’s contribution to overall growth is defined as that region’s GDP weight at the beginning of

each time period multiplied by that region’s annual average growth rate over the time period measured.

Source: Vanguard calculations based on data from the IMF World Economic Outlook, April 2013.

11

...and within that, China’s contribution should continue to dwarf that of other EM regions

Contribution to Global Real GDP Growth, by market

0.0

0.2

0.4

0.6

0.8

1.0

1.2

1.4

1.6

1.8

1980s 1990s 2000s 2010-2013 Next 5 Years

Glo

bal R

eal G

DP

Gro

wth

China CEE ASEAN-5 LATAM

Source: Vanguard calculations based on data from the IMF World Economic Outlook, April 2013.

Notes: Each region’s contribution to overall growth is defined as that region’s GDP weight at the beginning

of each time period multiplied by that region’s annual average growth rate over the time period measured.

ASEAN-5 countries comprise Indonesia, Philippines, Malaysia, Singapore and Thailand.

12

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

1995 1997 1999 2001 2003 2005 2007 2009 2011

0%

20%

40%

60%

Chin

a

India

Austr

alia

Germ

any

Mexic

o

Canada

Russia

South

Kore

a

Japan

Fra

nce

Bra

zil

Spain

Italy

United S

tate

s

United K

ingdom

Regional developments: China – heading for a hard landing?

Economic growth appears to have bottomed... Yuan appreciating modestly

The recession forced some

rebalancing to occur, more

is needed

Nearly 50% vs. the 15-25% that

is typical of large economies

Investment share of GDP, 2012 China net exports, % of GDP

0.12

0.14

0.16

2003 2005 2007 2009 2011

US

D/Y

uan

0

2

4

6

8

10

12

14

2004 2006 2008 2010 2012

Real G

DP

Gro

wth

(

Year/

Year

%)

Sources: IMF, National Bureau of Statistics of China, People’s Bank of China, U.S. Federal Reserve and Vanguard Investment Strategy Group. Data as of 19 September 2013.

13

Regional developments: ASEAN-5 economies – susceptible to an external slowdown

Real GDP growth in ASEAN-5 Share of ASEAN-5 exports by destination

-6

-4

-2

0

2

4

6

8

2005 2007 2009 2011 2013 2015 2017

Real G

DP

gro

wth

15%

17%

19%

21%

23%

25%

27%

40%

45%

50%

55%

60%

65%

70%

75%

2005 2007 2009 2011 2013

Share

of

glo

bal export

s destined f

or

AS

EA

N-5

Share

of

glo

bal export

s destined f

or

develo

ped m

ark

ets

Advanced ASEAN-5 (RHS)

Source: IMF, World Economic Outlook, April 2013 and IMF Direction of Trade Statistics and Vanguard calculations. Data as of 19 September 2013.

ASEAN-5 countries comprise Indonesia, Philippines, Malaysia, Singapore and Thailand.

14

Regional developments: India – structural challenges weigh on growth prospects

Real GDP growth slowdown Investment slump has become a more generalised slowdown

Real GDP growth and IMF forecasts Real effective exchange rate

Source: IMF, World Economic Outlook, April 2013, Ministry of Statistics and Programme Implementation of India. Data as of 9 September 2013.

0

2

4

6

8

10

12

14

2005 2006 2007 2008 2009 2010 2011 2012 2013

Real G

DP

(y

ear-

on-y

ear

gro

wth

)

0

2

4

6

8

10

12

2006 2008 2010 2012 2014 2016 2018

Real G

DP

(y

ear-

on-y

ear

gro

wth

)

Actual WEO, April 2013 WEO, October 2012 WEO, April 2012 WEO, September 2011

-10

-5

0

5

10

15

20

25

30

2006 2007 2008 2009 2010 2011 2012 2013Q2

Year-

on-y

ear

gro

wth

Private Consumption Investment Exports

85

90

95

100

105

110

115

2006 2007 2008 2009 2010 2011 2012 2013

15

-8%

-6%

-4%

-2%

0%

2%

4%

6%

8%

10%

2004 2006 2008 2010 2012 2014 2016

Real G

DP

gro

wth

(y

ear-

on-y

ear

per

cent change)

Brazil Mexico Others

Regional developments: LATAM - capital inflows have likely been QE-fuelled

Real GDP growth Capital flows by country (USDbn)

-30

-20

-10

0

10

20

30

40

50

60

70

2007Q1 2008Q1 2009Q1 2010Q1 2011Q1 2012Q1 C

apital flow

s b

y countr

y (

bill

ions o

f dolla

rs)

Brazil Mexico Rest of LA5 LA5 total

Notes: Other- Chile, Colombia and Peru

Source: International Monetary Fund, World Economic Outlook April 2013.

16

Regional developments: Emerging Europe – Euro crisis has weighed on growth

Gradual recovery from 2012 slowdown Exports to Euro area (Q2 2008=100)

-8

-6

-4

-2

0

2

4

6

8

10

12

2004 2006 2008 2010 2012 2014

Real G

DP

gro

wth

(per

cent)

CEE excluding Poland and Turkey

Poland

Turkey

60

65

70

75

80

85

90

95

100

105

2008 2009 2010 2011 2012 E

xport

s to E

uro

are

a (

Q2 2

008=

100)

Around 50% of CEE

exports are destined

for the Euro area

Source: International Monetary Fund, World Economic Outlook April 2013. Data as of 9 September 2013.

17

• We find that the average cross-country correlation between long-run GDP growth and long-run stock returns has been effectively zero

Investing in emerging markets: Be wary of the allure of economic growth

18


Real GDP growth and real stock returns 1970–2012

Source: Vanguard, based on data from the IMF and FTSE. For details, see Vanguard paper, Investing in emerging markets: Evaluating the allure of rapid economic growth (Davis, et al., April 2010).

y = 0.05x + 0.05 R² = 0.00

-2%

0%

2%

4%

6%

8%

10%

12%

14%

0% 2% 4% 6% 8% 10% 12%

Avera

ge A

nnual R

eal E

quity M

ark

et R

etu

rn

Average Annual Real GDP Growth

19

• We find that the average cross-country correlation between long-run GDP growth and long-run stock returns has been effectively zero

Three factors explain this seemingly counterintuitive result:

– Economic growth surprises matter; expectations are priced in

– GDP growth may not be a good proxy for earnings growth in a world of multinational companies

– Much of the capitalization growth in emerging markets comes from share issuance rather than rising stock prices


20

Economic growth surprises matter; expectations are priced in

US economic growth surprises vs. equity market returns, 1970-2012

US consensus economic growth expectations vs. equity market returns, 1970-2012

R² = 0.2364

-60%

-40%

-20%

0%

20%

40%

60%

80%

-10% -5% 0% 5% 10%

1-Y

ear

Sto

ck M

ark

et R

etu

rn

Economic Growth Surprises

R² = 0.032

-60%

-40%

-20%

0%

20%

40%

60%

80%

-8% -3% 2% 7% 1-Y

ear

Sto

ck A

head M

ark

et R

etu

rn

Economic Growth Expectations

Source: Vanguard, based on data from the IMF, FTSE and Philadephia Fed's Survey of Professional Forecasters. Notes: Economic growth expectations are defined as the 1-year ahead median forecast from the Philadephia Fed's Survey of Professional Forecasters. Growth Surprises are then defined as the actual change, relative to that expectation. Equity market returns are defined as spliced total market index For details, see Vanguard paper, Investing in emerging markets: Evaluating the allure of rapid economic growth (Davis, et al., April 2010).

21

GDP is a poor proxy for equity market earnings

GDP growth versus earnings growth 1999-2012

4.4%

12.3%

5.2%

8.6%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%


Avera

ge A

nnualiz

ed G

row

th

GDP Growth Earnings Growth


22

Share issuance is a large component of growth in market capitalisation

Shares outstanding Components of market cap growth Jan 1995 - Dec 2012

7.4%

1.4%

5.3%

4.8%

0.0%

2.0%

4.0%

6.0%

8.0%

10.0%

12.0%

14.0%

Emerging Markets Developed Markets A

nnualis

ed G

row

th

Share Growth Price Growth

75

100

125

150

175

200

225

250

275

300

325

350

375

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

2009

2010

2011

2012

Jan.1

995 =

100

EM DM


23

Often argued that EM is a thin market where active bets are more likely to pay off.

Theory and evidence suggest otherwise

Theory: The zero-sum game which holds in any market: before costs, for every investment that outperforms the index of a chosen market, there has to be another one that underperforms. But once costs are taken into account, it means that low-cost index funds will have a greater probability of outperforming higher cost actively managed funds.

Evidence: Our research suggests active managers no more likely to outperform in EM than in any other market.

Investing in emerging markets: Be wary of the argument that active management pays in EM

24

The theory of the zero-sum game

Below the market Above the market

Distribution of pre-cost returns

Benchmark return

Source: Vanguard

25

Importance of costs to the zero-sum game

Impact of costs

Average return after costs Average return before costs

Below the market Above the market

Source: Vanguard

26

0

5

10

15

20

25

30

35

40 Less than -

8%

-8 to -

7%

-7 to -

6%

-6 to -

5%

-5 to -

4%

-4 to -

3%

-3 to -

2%

-2 to -

1%

-1 to 0

%

0 to 1

%

1 to 2

%

2 to 3

%

3 to 4

%

4 to 5

%

5 to 6

%

6 to 7

%

7 to 8

%

More

than 8

%

Active Index

EM equity funds relative to MSCI EM Index

Dead funds:

Active 52

Index 0

Alive funds:

Active 130

Index 4

25% / 15% 75% / 85%

Outperforming / outperforming adjusted for survivorship bias

Source: Vanguard calculations, using data from Thompson Reuters Datastream and Morningstar, Inc.

Performance is over 5-years ending 31 December 2012. Past performance is no guarantee of future results.

27

Active managers underperform on average

Percentage of active equity managers underperforming their benchmark

Source: Vanguard calculations, using data from Morningstar, Inc.

Past performance is no guarantee of future results.

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

5 Years 10 Years 15 Years

EM

Survivors Only Corrected for Suvivor Bias

28

Debunking the market cycle myth

Percentage of EM equity funds underperforming prospectus benchmark

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

Bull Market: Jan-1998 to Aug-2000

Bear Market: Sept-2000 to Feb-2003

Bull Market: Mar-2003 to Oct-2007

Bear Market: Nov-2007 to Feb-2009

Bull Market: Mar-2009 to Dec-2012

Source: Vanguard calculations, using data from Morningstar, Inc.

Past performance is no guarantee of future results.

29

• EM equities outperform DM over the long run, but long periods of underperformance too

• Unwind of QE may harm EMs, but some fallback already priced in

• EM economies look set to continue to make a major contribution to world growth.....and within that, China will be very significant

• Prospects for EM economies look promising but risks abound (domestic and global issues, ie Fed policy, sovereign crisis, China slowdown)

• Don’t assume that EM equity returns will correlate with EM growth; avoid making portfolio decisions based on their expectations for a particular country or region’s economic prospects

• It’s not any easier to make active bets in EM markets

• EM assets have an important role in diversified portfolios

Conclusions

30

The information contained in this presentation does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so.

The information in this presentation does not constitute legal, tax, or investment advice. You must not, therefore, rely on the content of this presentation when making any investment decisions.

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© 2013 Vanguard Asset Management, Limited. All rights reserved.

VAM-2013-10-01-1163

Important information

Westaway citywire emerging markets.pptx final screen

Economy & Finance

em growth

emerging market equities

global gdp

role of emerging markets

lacklustre emerging

em equity

emerging market valuations

world growth