Emerging markets: Light at the end of the tunnel?

A perspective from E*TRADE Capital Management, LLC

07/12/18

In recent years, emerging markets have behaved a bit like a prairie dog trying to avoid a lawn mower. Every time the resurgent beast emerges for some much-needed sunlight, the mower comes back for another round, forcing the toothy tunnel rat to hit the deck.

And so it is that emerging market equities rose from the darkness to post double-digit returns in 2017, only to beat a hasty retreat in the first half of 2018. In fact, the MSCI Emerging Markets Index was up a whopping 37% last year, outpacing both US and developed market equities, before falling nearly 8% in the second quarter for its worst quarterly performance in nearly three years.1

With emerging market equities 15% off their January highs, is it time to reconsider this asset class? First, let’s acknowledge that after an extended period of weakness, some analysts have repeatedly called a bottom for emerging markets only to see volatility return. We’re not calling anything. Political instability still reigns in parts of the world—particularly Latin America—and a robust US economy and rising interest rates in developed markets might have siphoned off some of the capital that was flowing toward the developing world.

But at times like these, when fear can seem to trump common sense, it may be worth taking stock of the fundamentals underlying emerging markets. Let’s break it down:

Potential trade war scenarios

Sources: International Monetary Fund, McKinsey & Co.

The good

•  Emerging markets and developing economies make up roughly 85% of the world’s population, and their gross domestic product is expected to be double that of the developed world in 2018.2 That’s a lot of potential purchasing power to drive corporate earnings growth and stock valuations.

•  Global consumption is expected to increase to $62 trillion by 2025, with half of the growth expected to come from the developing world.3

•  65% of the world’s manufactured goods are expected to be sold in emerging markets by 2025. Already, more than half of the aggregate global demand for building materials, iron, and steel comes from emerging markets.3

It’s hard to argue against the growth prospects for emerging markets, but developing economies also come with risks:

The bad

•  Some emerging markets are plagued by political instability, which can weaken institutions, erode confidence, and dampen growth prospects. An extreme example is Venezuela, which is undergoing a political crisis that has resulted in food and medicine shortages.

•  Emerging markets are known for contagion. That is to say, instability in one region can quickly spread to other areas. We saw an example of this in June, when the Brazilian real reached its lowest level in two years and market selloffs followed throughout Latin America.

•  Many emerging markets are commodity-sensitive, which is great when commodities are having a good run but can make these regions vulnerable to swings in the price of crude oil, agricultural goods, and precious metals. This can be exacerbated if a trade war develops.

The ugly

Emerging markets have had a tough go of it over the past decade. For the 10 years ending June 30, 2018, the MSCI Emerging Markets Index posted an annualized return of 2.26%.1 That’s not much worse than the MSCI EAFE Index, a barometer of developed markets, which returned 2.84% during the same time.4 But it pales in comparison to the S&P 500’s more than 7% annualized return since 2008, which was generated with less volatility.5

Report: Emerging markets appear solvent

Despite their inherent risks, emerging markets offer plenty to be optimistic about—or, depending on how you view water in a glass, not as much to be concerned about as some would have you believe.

Research Affiliates, an asset manager well-known for asset allocation and smart beta investing, recently published some interesting research highlighting how the developing world has shored up its finances and become wealthier over the past two decades. Further, the report underscores what its authors believe to be the lack of a funding crisis among developing nations.

By looking at three metrics—external debt, foreign exchange reserves, and each country’s current account—the authors conclude that 80% of emerging market countries are at moderate-to-little risk of a funding crisis.6 This research indicates that the vast majority of nations in the developing world have adequate foreign reserves to pay their debts.

Valuations are compelling

Sure, the valuations yarn has been spun threadbare, but for good reason. On a forward price-to-earnings (P/E) basis, emerging market equities are priced at a roughly 15% discount to their developed market peers (ex-US) and are trading at nearly one-third of the forward P/E of US stocks.7

Context is key

As always, international investments should be considered within the broader context of a diversified portfolio. Emerging market exposure can provide a meaningful offset to a portfolio comprising primarily US and developed-market assets—particularly given relatively rich US stock valuations and low levels of correlation between global equities, which can provide diversification benefits.

As Warren Buffet famously opined, “Be fearful when others are greedy and greedy when others are fearful.” Greed and fear seem a little extreme to us. We’ll settle for common sense and taking the long view. It’s not as catchy, but for many investors it may be a good start.

1.  MSCI, Inc., MSCI Emerging Markets Index (USD), June 2018. https://www.msci.com/documents/10199/c0db0a48-01f2-4ba9-ad01-226fd5678111

2.  International Monetary Fund, World Economic Outlook (April 2018). http://www.imf.org/external/datamapper/datasets/WEO

3.  McKinsey & Co., “Global growth, local roots: The shift toward emerging markets,” August 2017. https://www.mckinsey.com/business-functions/operations/our-insights/global-growth-local-roots-the-shift-toward-emerging-markets

4.  MSCI, Inc., MSCI EAFE Index (USD), June 2018. https://www.msci.com/documents/10199/822e3d18-16fb-4d23-9295-11bc9e07b8ba

5.  S&P Dow Jones Indices, S&P 500®, July 11, 2018. https://us.spindices.com/indices/equity/sp-500

6.  Research Affiliates, “Pundits Predicting Panic in Emerging Markets,” June 2018. https://www.researchaffiliates.com/en_us/publications/articles/679-pundits-predicting-panic-in-emerging-markets.html

7.  Yardeni Research, July 4, 2018. https://www.yardeni.com/pub/mscipe.pdf