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Rekenthaler Report

With Emerging Markets, Bonds May Beat Stocks

The exception to the general rule?

Equities First!
Few Rekenthaler Reports have praised bonds. That owes partially to timing--fixed-income yields have been consistently low during this column's tenure--and partially to personal preferences. My portfolio has always consisted almost solely of equities. (Currently, it's at its lowest-ever level of 90%, as I trimmed my Morningstar (MORN) position last summer and have not yet reinvested the proceeds.)

It also reflects my view that stocks offer a free lunch, because investors overreact to equities' volatility, thereby improving their long-term returns. (Paradoxically, over time asset classes that are disliked outperform their more-popular rivals.) That argument, which comes from behavioral economists, does not lend itself to proof, but I think it is largely correct.

However, emerging-markets securities appear to be an exception.

Over the past 15 years, U.S. stocks have handily outpaced domestic bonds. The S&P 500 has appreciated by 8.75% annually, as opposed to 4.27% for the Bloomberg Barclays U.S. Aggregate Bond Index. But the same pattern did not hold for emerging markets. Their equities also returned 8.7%, but bonds followed closely behind, with the JPMorgan Emerging Market Bond Index rising 7.8%.

(As emerging-markets equities are in local currencies and most emerging-markets bonds are dollar-denominated, one might credit the relatively strong bond showing to strength in the U.S. dollar. But this explanation fails, as overall, emerging-markets currencies moderately appreciated against the U.S. dollar during that 15-year period.)

Thus, while stocks in the emerging markets did outpace fixed-income investments, the margin was modest--far less than would be expected, given that emerging-markets equities are 3 times more volatile than their bonds.

And the 15-year period presents emerging-markets stocks in their best light. Choosing shorter or longer increments makes the comparison even more lopsided. Over both the trailing 10- and 20-year periods, emerging-markets bonds comfortably outgained those countries' stocks. The track record is clear: Within the emerging markets, bonds have consistently been better than stocks.

Admittedly, performance comparisons are but a beginning. Strong relative returns can stem from temporary factors. Maybe the investment was deeply undervalued and now trades appropriately. (It may even be overpriced.) Maybe it benefited from unusual economic conditions. That emerging-markets bonds have outshone equities for 20 years does not prove their superiority. There must be some reason to believe that their edge will continue.

Shareholder Value
That reason, I believe, is corporate managements' responsiveness.

One naturally assumes that stock prices rise with a nation's gross domestic product growth. Greater production means higher revenues; higher revenues should mean larger profits; and larger profits should benefit shareholders. But not so. Researchers have struggled to find a positive correlation between GDP growth and stock-market returns. Of course, there are many ways to measure such a relationship. But most who have tried conclude, as does this Northern Trust report, that there is "no relationship" between the two items.

The problems lie with the second and third links of the chain. GDP growth does indeed create higher national revenues, which generally (although not necessarily, as they could come from smaller, privately held firms) flow to the country's publicly traded companies. However, those firms may not generate their revenues efficiently, building empires rather than cost-effective businesses. In addition, the profits that should accrue to shareholders may be eroded by corruption or land in corporate management's pockets.

Such has been the case with emerging-markets equities. Not every company in every country, of course. But overall, management's treatment of outside shareholders is less friendly than in developed markets, and in the United States particularly, where corporate managers are measured, first and foremost, by how shareholders fare. High stock price, high bonus. Lagging stock price, over enough time, not only a reduced bonus, but perhaps no job at all.

(Unlike with GDP growth, the relationship between a country's level of business corruption and its stock-market returns is positive. Cleaner nations, as scored by Transparency International, enjoy higher stock-market performances. Corruption is not the only factor to slow emerging-markets equities, nor is that problem absent from developed nations, but the point remains: Stocks do not respond to revenue growth alone.)

It's a Lower Bar
Such issues are immaterial for emerging-markets bonds.

To start, most are issued by governments, not corporations. On average, government bonds account for 60% of emerging-markets bond funds, and government-related agencies another 10%. Only 30% come from corporations.

What's more, those securities do not depend on profit growth. Fixed-income investors don't care if companies maximize shareholder value. What matters to them is that the bond is "money good"--that is, that it continues to pay its coupons and redeems bond owners when the issue comes due. Bond investors expect far less of corporate managements than do equity shareholders. All they require is that the company not embarrass itself.

That is a low hurdle, and it's easy enough for most firms to clear, barring a global recession. Also, emerging-markets debt tends to be relatively short-term, thereby reducing default risk. The upshot: Emerging-markets bonds deliver a yield premium, which they predominantly deliver, while emerging-markets stocks promise a growth premium, which they usually fail to remit.

These things may shift. I know fully how the securities performed; I am moderately confident as to my explanation why; and I have no idea whatsoever if what was, no longer will be. Perhaps the people who run publicly traded emerging-markets companies are changing their ways. They control a great amount of potential shareholder value. If they unlock it by increasing margins, emerging-markets stocks could surge. In that case, this column will look foolish in hindsight.

Such is the risk is putting thoughts to print. Such also, is why this column contains the word "may" in its headline. Counterarguments may certainly be made for emerging-markets equities. (I would not be surprised to receive a few, from those who run and/or market such funds.) Ultimately, they may prove to be correct. But given that similar counters could have been offered through the past 25 years, skepticism is warranted.


John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.

John Rekenthaler has a position in the following securities mentioned above: MORN. Find out about Morningstar’s editorial policies.