Any investor with even a passing interest in emerging market equities will know that their short-term performance is closely linked to developed markets. Fund flows from foreign investors and economic news from the US and other major economies usually set the tone and direction for stocks in most other parts of the world.
The table below shows the correlation of monthly returns between the MSCI USA, the MSCI Emerging Markets and three major regional benchmarks – MSCI Asia ex Japan, MSCI Latin America and MSCI EM Europe and Middle East – over the last 10 years (all based on Bloomberg data). As you can see, all EM indices show significant correlation with the MSCI USA.
| MSCI Asia ex Japan | MSCI Emerging Markets | MSCI EM Europe and Middle East | MSCI Latin America | MSCI USA | |
| MSCI Asia ex Japan | 1 | 0.969 | 0.817 | 0.822 | 0.788 |
| MSCI Emerging Markets | 0.969 | 1 | 0.902 | 0.917 | 0.824 |
| MSCI EM Europe and Middle East | 0.817 | 0.902 | 1 | 0.848 | 0.765 |
| MSCI Latin America | 0.822 | 0.917 | 0.848 | 1 | 0.794 |
| MSCI USA | 0.788 | 0.824 | 0.765 | 0.794 | 1 |
What’s more, these correlations with US equities have been rising over time, as the charts below show (the relevant section is the green chart at the top of each group). Correlations rose substantially during the 2008-2009 crisis and have remained high ever since.
MSCI Asia ex Japan and MSCI USA
MSCI Emerging Markets and MSCI USA
MSCI EM Europe and Middle East and MSCI USA
MSCI Latin America and MSCI USA
Unsurprisingly, tighter correlations with the developed world have also meant tighter correlations between different emerging markets themselves, as the chart below of the relationship between the MSCI Emerging Markets and the MSCI Emerging Europe and Middle East shows.
Given this, it would be easy to conclude that there is little point to making long-term investment in emerging markets. If they are increasingly likely to rise and fall with developed world equities, then most sensible approach must be based on short-term market timing. In other words, try to capture the upswings in which they rise further than developed markets and then get out before they fall harder.
But is this true? No. Looking at the high correlations in isolation misses a crucial point. Developed markets and emerging markets tend to rise and fall together month-by-month, week-by-week and even day-by-day. And emerging markets certainly tend to fall further when markets turn down, as foreign investors pull out and repatriate funds.
However, over the past decade, emerging markets have cumulatively outperformed by more when stocks are rising than they have underperformed when they are falling. As a result, they have delivered higher long-term returns despite suffering much bigger sell-offs on occasion.
The chart below shows the performance of the above five indices on a single chart, with February 2002 as the starting point. As you can see, all the emerging market benchmarks shown have handily outperformed the MSCI USA (the green line) over the past decade.
(Yellow line = MSCI Latin America, orange line = MSCI Emerging Markets, red line = MSCI EM Europe and Middle East, white line = MSCI Asia ex Japan)
And this remains true even if we focus on the post-crisis period over which correlations have been higher than in the past – ie since the end of 2008.
Tighter correlations between developed and emerging markets may make emerging market investment less useful for investors who have relied on them to diversify portfolios. But it says nothing about the chances of them delivering higher overall returns.