Developed markets and emerging markets have long been on opposite sides of the investment world. Few investors realize it, but that’s no longer the case. And the shift could completely change how markets value risk, and stocks – with big implications for your portfolio.
It used to be that in developed markets (like the U.S., Europe, and Japan), things were comfortable and easy, and there weren’t many surprises. Politics didn’t matter much to share prices. Economic growth was slow and steady, and stock returns were unspectacular but predictable.
Markets were well regulated and easy to trade. Of course you could be a victim of bad brokers. But if you were a little bit careful, and a little bit lucky, you could avoid the landmines.
And then there were crazy emerging markets (like most of Latin America, Africa, and much of Asia), the wild west of investing, where anything could happen. Bad politics could erase years of market gains in a matter of moments. Emerging economies grew faster, but were a lot more volatile.
Stocks could boom one year, and stumble into the graveyard the next. And if there was no rule of law, you could lose everything to corrupt government officials, or on a stock of a company that never existed.
Since emerging markets were a lot less predictable than developed markets, they were viewed as a lot more risky. So for years they’ve traded at a lower valuation (like the price-to-earnings ratio) than developed markets.
That means that for every dollar (or ruble, or peso) of earnings, investors pay less in an emerging market than they do in a developed market. The graph below shows the differences in P/E ratios in different markets over time (the gray area shows how much cheaper emerging markets are than the S&P 500).
But two things are happening that are turning the idea of developed and emerging markets upside down… so much so that the distinction soon won’t even matter anymore.
First, a lot of companies that are listed in developed markets – most notably, the U.S. and London, along with Hong Kong – aren’t American (or British or Hong Kong) companies. Thanks to globalization, General Electric and Vodaphone and HSBC, and hundreds of other big listed stocks, get a lot (if not most) of their revenues from emerging markets. That, and/or they’re dependent on demand in emerging markets.
So, to say these stocks are part of a “developed market” just because they’re listed on one misses the point of the nature of the underlying business. For a lot of companies in a lot of markets, this line between developed and emerging market companies hardly exists any more.
That’s one reason that there’s less of a dividing line between emerging markets and developed markets. The bigger reason is politics.
When I worked for a political risk consulting company a few years ago, we would talk about how an emerging market was one where politics mattered to markets. That meant that personalities (that is, the people in power) were bigger than, and more important than, the institutions those people headed up. Who’s president, what the parliament is doing, what kind of people are making policy – all of that could be the difference between making or breaking a market.
In contrast, in developed markets, institutions (like the judiciary, or a country’s constitution, or the civil service) are supposed to matter more that specific personalities. It’s the institutions that keep things rolling, day after day, regardless of who’s in power. The system survives, and the people at the top don’t really have that much of an impact on most of what goes on.
Today in emerging markets, politics still matter a lot… like in Brazil and South Africa and Malaysia and Russia. Who the president is and what crazy things he’s doing can completely change the business and investment environment.
And bad government can destroy the stock market for years. (Or – rarely – a good government can transform a country in a positive way).
The big change is that developed markets are looking a lot more like emerging markets when it comes to politics. From Germany to Japan to the U.S., politics in many developed markets are a lot more polarised than they’ve ever been before. Different sides don’t want to talk – they only want to yell. And after a while, a strong personality harnesses one part of this polarisation. That’s what can threaten institutions. And that’s a big risk.
The current presidential campaign in the U.S., and the popularity of Donald Trump, is one reflection of this. A few decades ago, politics in developed markets might matter only because of their impact on specific policies or sectors. But in recent years, and now, personalities are becoming bigger than the institutions they inhabit (or which they hope to inhabit). If personalities can change those institutions for the better, it’s a good thing. But it’s a big risk – as the history of many countries in emerging markets has shown.
Markets don’t like that kind of uncertainty. Political risk is a big reason for the valuation gap between developed and emerging markets.
A main reason that a lot of people invest in emerging markets is that they think that over time, the valuation levels (like the P/E) of some emerging markets will rise. As share prices rise, the discount to developed markets would close.
But the opposite could happen: The valuations of developed markets could fall, and close the gap with emerging markets by dropping down to them. Or that discount could remain the same, as valuations of both emerging and developed markets fall – as political risk across all markets rise.
As listed companies become more global in nature, and as politics in many developed markets become more personality-based, that just might happen.