Explore the role of emerging market stocks in portfolio diversification.
CIBC Investor’s EdgeApr. 08, 2024
5-minute read
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What are emerging markets? Put simply, they're not developed markets. Emerging markets typically have different standards of political governance, rule of law and property rights — among other factors — compared to developed markets. Emerging markets include major economies such as Brazil, China and India, along with many smaller countries and regions.
The world in stocks
To provide context for emerging markets, we show major regions and the top 10 markets, by their share of world stock market capitalization.1
Share of world stock market capitalization by region
The current list of the top 10 global stock markets includes 2 emerging markets: China and India. Since emerging markets were launched as a stock index in 1988, the share of emerging markets in world stock market capitalization has waxed and waned. It currently stands at just under 10%, versus 26% for developed markets outside Canada and the United States.
Stock market capitalization does not necessarily reflect economic output. For example, the United States represents over 60% of global stock market capitalization but about 25% of global GDP2, while emerging markets represent about 10% of global stock market capitalization but about 40% of global GDP3. Investors are effectively pricing in premiums and discounts to economic output for global stock markets, based on factors such as innovation, productivity, depth of capital markets and rule of law.
Global market performance
We divide international markets into emerging markets (EM) and the developed markets of Europe, Australasia and the Far East (EAFE). The following table compares the returns of emerging markets to those of Canada, the United States and EAFE over 5-year periods from 1990 to 2019, plus the most recent 4-year period from 2020 to 2023.4
Annualized sub-period returns, 1990 to 2023
Market
1990 to 1994
1995 to 1999
2000 to 2004
2005 to 2009
2010 to 2014
2015 to 2019
2020 to 2023
Overall
Canada
4.5%
17.0%
3.6%
7.7%
7.5%
6.3%
8.6%
7.8%
US
12.9%
29.3%
−5.8%
−2.3%
17.8%
14.3%
12.6%
10.6%
EAFE
5.8%
13.8%
−4.4%
1.3%
7.9%
8.6%
5.9%
5.4%
EM
25.6%
2.6%
0.9%
12.8%
4.2%
8.4%
1.1%
7.8%
Looking at these sub-periods, the returns of emerging markets were sometimes much higher and sometimes much lower than those of developed global markets. Overall, based on the 34-year period, emerging markets showed a similar return to that of the Canadian market, but with a much higher level of volatility.5
Annualized return and volatility, 1990 to 2023
Market
Return
Volatility
Canada
7.8%
15.8%
US
10.6%
16.4%
EAFE
5.4%
15.6%
EM
7.8%
25.9%
Volatility, measured by standard deviation, implies that 95% of returns tend to fall within 2 standard deviations above or below the average return. This is a very wide range for emerging markets and gives a rough sense of how unpredictable their returns can be. However, it’s hard to capture the experience of large and sudden swings up and down with a statistical measure, just as it is hard to capture the experience of a rollercoaster ride with a written description. The high volatility of emerging market stocks is also associated with large losses in market crashes.6
Annual returns in market crashes
Year
Canada
US
EAFE
EM
2000 — Tech crash
7.4%
−5.6%
−10.6%
−27.9%
2001 — Tech crash
−12.6%
−6.4%
−16.3%
3.7%
2002 — Tech crash
−12.4%
−22.8%
−16.5%
−6.9%
2008 — Financial crash
−33.0%
−22.6%
−30.0%
−42.5%
2022 — Tech crash
−5.8%
−12.5%
−8.1%
−14.3%
Emerging markets have exposure to different risks and opportunities than developed markets, including infrastructure development, consumer spending, population aging, government debt and foreign currency borrowing, to name a few. As a result, emerging markets have a less than perfect correlation with developed markets.7
Market correlations, 1990 to 2023
Market
Canada
US
EAFE
EM
Canada
n/a
0.46
0.66
0.68
US
0.46
n/a
0.70
0.21
EAFE
0.66
0.70
n/a
0.59
EM
0.68
0.21
0.59
n/a
Based on the overall period from 1990 to 2023, emerging markets have been more correlated with Canada than the United States, although correlations have changed over time. For example, Canada and emerging markets were highly positively correlated during China's expansion in the 2000s — due to Canadian exports of energy and materials — and were less positively correlated in the following decade. The United States was negatively correlated with emerging markets in the 1990s — when the US had a technology boom while several emerging markets experienced currency crises — and became positively correlated with emerging markets in the following decades.
Overall, the theme of "convergence" — rising living standards in some emerging markets and their growing similarity to developed markets — may affect the potential diversification benefit of emerging markets for North American investors.
Key takeaways
Here are the key points about emerging markets in relation to global stock markets:8
Emerging markets currently represent about 10% of world stock market capitalization, compared to about 26% for developed markets outside Canada and the United States.
Emerging markets currently have less stock market capitalization than would be suggested by their economic output, while developed markets have more.
Returns of emerging markets have varied significantly from those of developed markets, sometimes for periods of a decade or longer.
Risks of emerging markets, whether measured by volatility or crashes, have been greater than those of developed markets.
In the past, emerging markets have been more correlated with Canada than the United States. The extent to which some emerging markets "converge" with developed markets may affect their diversification potential for North American investors.
1 Stock market weights based on portfolio composition of Vanguard total world stock ETF (VT). Source: Vanguard US. Data as of January 31, 2024.
2 US share of global GDP. Source: World Bank. Data as of 2021.
3 Emerging markets share of global GDP. Source: Morgan Stanley. Data as of 2020.
4 Index total returns including dividends for Canada (S&P TSX Composite), United States (S&P 500), EAFE (MSCI EAFE) and emerging markets (MSCI Emerging Markets). Returns in Canadian dollars, based on full currency exposure to foreign stocks. Source: Norman Rothery, asset mixer.
5 Index total returns as above. Volatility is standard deviation of annual returns.
6 Index total returns as above.
7 Index total returns as above. Correlation based on annual returns from 1990 to 2023.
8 All historical observations based on the period from 1990 to 2023.
