Emerging Markets in an Upside Down World
The argument that the risk is mispriced in the developed world, not the emerging one.
Summary
Booth, formerly head of research at Ashmore Group which specialises in emerging market debt, argued that investors systematically misprice emerging market risk relative to developed market risk.
His central claim is that the categories are backwards. Developed markets carry risks that investors do not price because those risks have not materialised recently: very high government debt, unfunded pension and healthcare obligations, ageing populations, banking systems dependent on state support, and monetary policy operating at the limits of its tools. Emerging markets carry risks that investors overprice because they have materialised recently, while their fiscal positions, demographic profiles, growth rates and foreign exchange reserves are frequently better.
His structural argument is about capital allocation. Global institutional portfolios allocate to emerging markets in proportion to their share of market capitalisation indices, which is far below their share of global output and further below their share of growth. Booth argues this reflects institutional convention rather than analysis, and that as emerging market savings pools grow and as their own institutions allocate capital, the flows will reverse: the capital exporters will be the countries currently treated as recipients.
He also argues that the assumption of a risk-free rate located in developed government bonds is an artefact of who has historically set the conventions rather than a fact about risk.
The argument was made in 2014 and the following decade did not support the investment conclusion: emerging market equities and debt underperformed developed markets substantially, and the dollar strengthened. The structural observations about debt, demographics and index construction remain accurate. Booth's professional interest was in the asset class he was arguing for, which readers should note.
Key takeaways 7
- Investors price emerging market risk on recent experience and developed market risk on the absence of it, which is not an assessment of either.
- Developed markets carry high government debt, unfunded obligations and ageing populations that current pricing does not reflect.
- Global portfolios allocate to emerging markets in proportion to index weight rather than to output or growth.
- Index weights reflect market capitalisation and free float conventions rather than any analysis of expected return.
- As emerging market savings pools grow, their own institutions will allocate capital and the flows will change direction.
- The assumption that developed government bonds define the risk-free rate is a convention rather than a fact about risk.
- The investment conclusion was not borne out in the decade after publication, during which emerging markets underperformed substantially.
Who should read it
Allocators considering emerging market weightings who want the structural argument, weighed against the subsequent decade's returns and the author's interest.
Where it sits in the reference 2
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