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The importance of geographic diversification
Building a portfolio that is resilient to negative economic factors is important for earning consistent returns and preserving wealth. A key factor to achieving this resilient portfolio is through diversification. One common approach of diversifying is by investing in different asset classes. Investors can also diversify by investing in different global economies, and with recent advancement in technology, this has become easier and affordable for Indian investors.
So, which economies should one invest in?
A look at emerging markets
As investors evaluate global markets, the idea of investing in emerging markets seems intriguing. Many emerging markets are poised to grow rapidly in the coming years, and rising GDP is typically accompanied with rising income, which investors are tempted to assume should have a positive effect on the local stock market. Figure 1 lists the projected GDP growth of various regions in the world in 2020.
Figure 1: Projected annual real GDP growth rate in 2020 by region.
Of the regions with emerging economies, Asia is poised to grow the fastest, specifically: South, Southeast, and East Asia.
But can one simply use GDP as an indicator of financial market growth?
Comparing GDP growth to market returns
One problem with this approach is that GDP is a measure of economic growth and not a true indicator of financial market growth. In the global economy, the increased consumption that comes with economic growth may not always translate to increased revenue for local companies. For example, if the income level of Indian residents goes up, resulting in increased streaming consumption via Netflix and Spotify, then the growth generated in India will not be reflected in the local Indian stock market, since these companies are publicly traded in the US.
Thus, GDP growth alone is insufficient as a standalone indicator – especially for emerging markets. In Figure 2, we plot returns of indices comprised of mid to large-cap companies for different countries against average real GDP growth.
Figure 2: Returns of mid to large-cap indices vs. average real GDP growth from 2017-2019. Returns are USD based to exclude effects of FX fluctuations.
As you can see, there is a poor correlation between GDP growth and stock market returns (the data points are scattered randomly). Fast-growing Southeast Asian countries – such as Vietnam, Philippines, and Indonesia – averaged returns between 0.68% to 20% over the past three years, despite their real GDP growing +5% per year on average.
If we look at the top 5 markets with the highest returns, US and China top the list, followed by Taiwan, India and Brazil. As an investor from India, you likely already have exposure to one of the fastest growing emerging economies, and can gain access to the Indian market easily, so let’s focus on the other markets.
Market insights
China
Despite the ongoing US/China trade war, China’s stock market performed well – up 23.9% in 2019 (compared to a 25% loss in 2018). Improved investor sentiment and government subsidies played a large role in this growth. According to Nikkei, the Chinese government gave out subsidies that amounted to 5% of net profit earned by China’s public companies (US $22.4 billion) in 2018, and increased it by another 15% in 2019. Note that the practice of subsidizing local industries to bolster exports is in violation of World Trade Organization policies. It is yet to be seen if this practice will continue, as it is one of the main points of contention between the US and China. Also, China’s stock market is notoriously volatile since it is largely based on retail investors’ activities.
Taiwan
The Taiwan index (TAIEX) had one of its best performing years in 2019, propelled by foreign investors pouring capital into the country. According to Bloomberg, more than US $6 billion dollars came into the country, with half being invested into Taiwan Semiconductor Manufacturing Co (TSMC), the largest semiconductor manufacturing company in the world by volume, and whose share price climbed by more than 67% last year.
Brazil
Despite slow economic growth (real GDP growth was only 0.9% in 2019), the Brazilian index (Bovespa) gained 24% last year. Investors are bullish about the Brazillian stock market. They expect that a combination of low interest rates, low inflation and continuing economic reforms from the current administration will further bolster the economy. However, note that despite the surge in recent years, Brazil has a long history of corruption and political instability, which can lead to high market volatilities.
United States
Don’t count out the US just because it is a developed market. The US stock market does not just capture the US economy, but also the global economy. More than 40% of the revenue of S&P 500 companies are derived from outside the US. What’s more, the S&P 500 has grown more than 2X in the past decade. Goldman Sachs provides a relatively positive outlook for 2020, due to dissipating US/China trade tensions and continued strength in consumer spending (two-thirds of the US GDP).
With this in mind, how can one go about investing in these international markets?
US stock market as gateway to global economies
As a retail investor, one of the easiest ways to access international markets is to invest through ETFs traded in the US stock market. For example, BlackRock’s iShares has an ETF that invests in Chinese mid to large-cap companies (ticker: MCHI). And, if you are not sure which country to diversify into, there are emerging market ETFs that capture many of the countries listed here (for example BlackRock’s EEM or Vanguard’s VWO).
Conclusion
- Global diversification is key in helping achieve a resilient portfolio.
- Technology has made this easy and affordable for Indian investors.
- While investors are keen to invest in emerging markets, be sure to consider factors outside of just GDP growth.
- Finally, take a look at the US market as an easy way to invest in not only a developed market but also these emerging economies.
