Economic Growth Does Not Equal Market Growth

Christine Benz: Hi, I'm Christine Benz from Morningstar.com. Emerging-market stocks have been on a tear over the past decade with annualized returns averaging about 10%. But are those returns sustainable?

Here to discuss that question with me is Fran Kinniry. He is principal in Vanguard's Investment Strategy Group.

Fran, thanks for being here.

Fran Kinniry: Thank you, Christine.

Benz: So this is a hot topic, Fran, emerging markets, we've seen a lot of investors gravitating to emerging markets. A question is, what should their expectations be for this asset class given the runup that we've seen over the past decade?

Kinniry: Well, you mentioned a 10% return over the last decade, and if you put that in perspective the U.S. over the same 10 years has had a negative return.

Benz: Right.

Kinniry: So you would hope that investors are diversifying internationally or in emerging markets for the diversification properties, but we're a little worried that it's a similar story that we've seen in the past, whether it would be technology or growth stocks in the late 1990s, that inventors may be just buying the performance.

Benz: Performance-chasing. So, when investors think about growth certainly they think, well, emerging markets are going to be where you need to be because the economic growth appears to be a lot stronger and the prospects appear to be stronger. But your firm has shown that economic activity does not equal market activity. So, can you talk about what you found there?

Kinniry: Sure, that's exactly right. We've looked at all metrics that you could possibly look at to try to give you a handicap edge on the forward-looking capital markets, and our findings were that GDP growth actually had zero correlation to future capital market expectations.

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So, GDP growth, there is no doubt in our mind or in anyone's mind quite frankly, that the emerging market economies are going to have GDP growth substantially more than the developed international and the U.S. However, that does not necessarily translate into outperforming capital markets.

The analogy I always use is growth companies and value companies. So whether they'd be in the international sector or the U.S. sector, the style boxes that are out there, you see the growth companies by definition have typically 2.5 to three times P/E earnings growth estimates higher than value companies, and yet when you look at the returns, value companies outperform growth companies.

So, really the number-one metric about forward capital market returns is how much someone is willing to pay, price to earnings, and so what we have seen in the emerging markets is certainly earnings expected to grow much more quickly, but the P/E ratios have actually all of a sudden become a premium where they have historically been at a discount to the developed world.

Benz: So when you think about your firm's projected returns for developed versus developing, can you give us a sense of what you're expecting over the next several years or the next decade?

Kinniry: Sure. With all that being said we don't necessarily think there is a bubble in emerging markets either. We just think expectations and the cash flows that have gone in there at such an accelerated pace look to be ahead of themselves. Valuations look compressed all over the place, which means that there is nothing really in bubble territory. There is also nothing really selling ridiculously cheap, either.

And so our expectations for both the U.S., the developed, and the emerging is somewhere around 8% to 10% in a 10-year forecast with a very wide distribution around that. The standard deviation is still 5%, which means within a 95%-confident band, you're still talking zero to 20% on a 10-year forecast.

Benz: So broad range. So, when I am thinking about setting a portfolio's balance between developed and developing markets, what are some ways to think about that question and what are some useful baselines that people can use?

Kinniry: Yeah, we typically take first of all our equity portfolio and then we put about 30% to international, 70% U.S., and then within the international space we very much believe in market proportional, which means no different than how the U.S is market-cap weighted, we would take the cap weighting of the international space. And so within that you'd see that the emerging market takes up about 25% of the international space.

Benz: Well thanks, Fran that's some helpful guidance on what's been a very hot topic recently. We appreciate you sharing your insights.

Kinniry: Well, thank you, Christine.

Benz: Thanks for watching. I'm Christine Benz from Morningstar.com.