Emerging Market EquitiesSubmitted by Journey Advisory Group, LLC on April 15th, 2020
The case for emerging market equities:
The case for emerging market equities can be made on four fronts or themes:
- Inverse correlation to the U.S. Dollar
- Performance goes in cycles
Emerging Market equities look attractive on several fronts. The first being valuation as the MSCI Emerging Markets Index trades at a sizable discount to other indexes like the S&P 500, Russell 2000, or MSCI EAFE. The chart immediately below is from JPMorgan Asset Management and reflects indexes as of close on 4/3/2020.
Speaking more to valuations and commodities, several Emerging Market countries tend to be positively correlated with activity in commodities. As illustrated by the following chart from Katusa Research, commodities have never been this cheap relative to equities and signal value on a historical basis.
Over the long-term, demand for commodities coupled with loose monetary policies from global central banks may provide tailwinds to commodities and push them higher. Of course, this is dependent on supply/demand constraints, consumer confidence and spending, and other factors. The following chart from Yardeni Research helps to illustrate the correlation between Emerging Markets (red) and commodity prices (blue).
Third, Emerging Market equities tend to (but not always) trade with an inverse correlation to the U.S. Dollar. The idea being that as the U.S. Dollar declines, Emerging Markets tend to benefit. So, what can make the U.S. Dollar decline? Given the indebtedness of the U.S. Government, unprecedented stimulus measures from the Fed and Congress, and what will likely be reduced confidence in the currency, Emerging Market Equities will likely benefit from a weaker U.S. Dollar. The following chart from Blackrock illustrates the negative correlations in both Emerging Market equities and debt from December 2009-2019.
Lastly, performance goes in cycles. While U.S. markets have outperformed international developed and emerging market counterparts for several years, it would be a mistake to extrapolate that outperformance to extend for an indefinite period of time. As illustrated by the following Callan Chart, Emerging Market equities have been a top performing asset class in 2003, 2005, 2007, 2009, & 2017. While our portfolios are currently highly biased to U.S. markets, we feel that it’s prudent to shift a greater weighting to Emerging Markets at this time on the basis of the four themes discussed.
In conclusion, it’s important to note that not all Emerging Market economies are created equal. We have a more favorable view of more advanced economies in Asia including China, South Korea, & Thailand. As we recently discussed in our talking points email, we prefer Asian economies on the basis of favorable demographics, higher savings rates, favorable economic freedom scores, and higher growth rates. On the flip side, we have less favorable view of more commodity-dependent, more cyclical, higher-risk countries like Brazil, South Africa, and Russia. As such, country exposure is an important factor that shapes our decision-making process. With this in mind, we have elected to increase our exposure to Asian economies through the Matthews Asia Innovators Fund. https://us.matthewsasia.com/resources/docs/pdf/literature/fact_sheet_matfx.pdf
As the old saying goes, ‘without risk, there is no reward’ so let’s balance the case for Emerging Markets by examining some of the risks:
- Vulnerability to a rising U.S. Dollar and currency risk
- Just as Emerging Markets tend to benefit from a weaker U.S. Dollar, they tend to be vulnerable to a rising Dollar. This comes up a lot in Emerging Market debt as a great deal of that market is denominated in U.S. Dollars. In this case, a falling U.S. Dollar is the equivalent to a tax a cut whereas a rising U.S. Dollar is the equivalent to a tax hike. Speaking more to currency risk, many Emerging Market countries have much more volatile and less liquid currencies than developed market countries.
- Relative strength/performance concerns
- Emerging Market equities have lagged their domestic counterparts considerable over the last decade or so.
- The following chart from Morningstar highlights performance comparing the S&P 500 ETF SPY (in blue) to the Vanguard Emerging Markets Index ETF VWO (in orange). As we highlighted earlier under point 4 of the case for emerging markets, performance tends to move in cycles so what was true in the past does not always play out in the future.
Chart from Morningstar.com
- Leverage to commodities
- Just as higher commodity prices tend to benefit Emerging Market countries, weaker prices tend to be a headwind. Point 2 under the case for Emerging Markets speaks further to this point.
- Political risk/corruption
- In general, Emerging Market countries tend to see greater political risk, corruption, higher levels of Government intervention, and less economic freedom. The Heritage Foundation does a nice job of ranking economic freedom levels in their annual Index of Economic Freedom publication. https://www.heritage.org/index/pdf/2020/book/2020_IndexofEconomicFreedom_Highlights.pdf
- Liquidity risk
- Many of the securities in the Emerging Market indexes have much less liquidity than some of blue-chip names on the NYSE such as Apple or Microsoft. As such, many are subject to higher volatility and carry higher risk metrics like Beta and Standard Deviation.
- Transparency risk
- Several of these countries may have less strict rules than the United States in terms of accounting, transparency, property rights and legal protection, and so forth.
- Capital flight
- Capital flight is more of an issue when U.S. interest rates are rising and funds from Emerging Market countries head back to the United States. It also becomes an issue in times of crises as funds tend to flee towards higher quality, safer havens. As the following chart from the Institute of International Finance shows, capital outflows since the Covid-19 crisis began well exceeds previous shocks like the Financial Crisis and others
This commentary is provided for general informational purposes only and should not be construed as personalized financial or investment advice. Information has been obtained from sources deemed reliable but is not guaranteed. Securities and investing involve the risk of loss. No strategy can assure a gain or the avoidance of loss. Any comparative indices shown are unmanaged and are provided as an indication of the performance of a given segment of the capital markets. Indices cannot be invested in directly, and the returns shown do not reflect any fees, costs, or expenses. Past performance should not be relied upon as an indicator of future performance. Forward looking comments necessarily involve known and unknown risks and are subject to change. There can be no assurance that forward-looking statements will prove to be accurate, as future events could differ materially from those anticipated. We undertake no obligation to update forward-looking statements if circumstances or opinions should change.