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The turmoil in the Chinese stock market has been in the press for a few months now. Investors are increasingly worried about Emerging Markets (EMs), which have underperformed Canadian, U.S. and International Developed equity markets over the last five years. An extremely negative article in the Guardian seems to give credibility to those worries. But are they justified?

What the article says

The Guardian article quotes an analysis by investment bank NN Investment Partners, which concluded that a $1-trillion capital flight has occurred in EMs in the last year. This rush to exit is apparently due to fears of a coming Chinese recession, of the slowing growth of emerging economies, of the risk of competitive currency devaluations from developed countries and of the uncertain military situation in Turkey (due to its proximity to Syria).

Is This a Surprise?

Only the reported $1-trillion capital flight from EMs is new to us. This number may reflect the market’s discomfort with emerging markets. However, EM stocks are valued at much lower prices relative to their earnings than are those of Developed Markets: this represents a substantial risk premium. In other words, EMs appear riskier but they are also priced for a higher return potential.

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P/E Multiples in International Markets (As of August 31, 2015)

Source: PWL Capital

A Look at the Facts

While the Guardian article does not suggest bailing out of EM equity, its extremely negative tone could be interpreted as such. But despite the major drop recorded in August, the MSCI Emerging Market Index still posts a positive 0.4% year-to-date return in Canadian dollars. Another fact that should guide us is that Emerging Markets are considered riskier than Developed Markets at all times, not just this year. Finally, let’s remember that the investors who bailed out of European Equity after the PIGS (Portugal, Ireland, Greece and Spain) crisis erupted in 2011-2012 missed out on a total return of 20.8% in the last three years. Bailing out when a market gets riskier is not a recipe for improved returns.

How PWL Manages Emerging Market Risk

We believe Emerging Market risk should be managed rather than avoided. PWL does this by limiting EM investments to 10% to 20% of equity allocations. We avoid concentrations on any individual country or security. And finally, PWL invests through funds that focus mainly on EM stocks trading on major markets such as London, Hong Kong and New York. This last restriction ensures that the companies in the portfolio comply with the highest standards of accounting, governance and other regulatory requirements.