John Gorlow
| Aug 16, 2019
When will Emerging Markets come back to life? Ten years is a long time for buy-and-hold investors to be patient, especially when comparing the subpar returns of Emerging Markets to the stratospheric gains of the S&P 500 Index over the same decade. The data tell a nuanced global story, punctuated by politics, protectionism, nationalism, trade wars, climate change, and unexpected winners and losers. In our view, the story is far from over. We’ll share our perspective and advice after a look at the July markets.
July Market Report
World Asset Classes
It was a volatile month for stocks. The MSCI All Country World Index returned 0.29% bringing year-to-date (YTD) returns on the index to 16.57%. US stocks were the top performers, followed by international developed equities and emerging markets, respectively. US crude prices were down slightly. Gold prices continued to climb. Yields on ten-year government bonds hovered around 2%, near the low end of their range.
US Stocks
US equities as measured by the S&P 500 Index returned 1.44%, bringing YTD returns to 20.24%. For the one-year period, returns on the index were 7.99%. Small caps underperformed large caps. Value stocks underperformed growth stocks marketwide.
International Developed Stocks
Developed markets outside the US as measured by the MSCI World-Ex USA Index returned negative -1.21%, underperforming the US and outperforming emerging markets. YTD returns on the index were 13.25%. Small caps underperformed large caps. Value underperformed growth across both large and small cap categories.
Emerging Markets Stocks
Emerging markets as measured by the MSCI Emerging Market Index returned negative -1.22%, bringing YTD returns to positive 9.23%. Small caps underperformed large caps and emerging market value stocks outperformed emerging market growth stocks.
Real Estate Investment Trusts (REITs)
US REITs outperformed international REITs returning 1.6% versus negative -0.57% for non-US REITs. US REITs returned 18.54% YTD, versus 14.03% for non-US REITs.
Fixed Income
The 10-year U.S. Treasury Bond closed at 2.01%, flat from last month and down from 3.03% in April 2018. The FOMC lowered interest rates by 0.25%, their first cut since 2008. Barclay’s US Government Bond Index finished the period with YTD returns totaling 5.03%. Treasury inflation protected securities (TIPS) gained 0.36%, bringing YTD returns to 6.53%. Barclay’s municipal bond index returned 0.81% for the month and 5.94% YTD. Barclay’s US High Yield Corporate Bond Index added 0.56%, bringing YTD returns on the index to 10.56%. Oil decreased to close at $58.01 from last month’s $58.20. Gold was up, closing at $1,426.30 from last month’s $1,412.50.
Feature Article
A Global Tale
The term “Emerging Markets” (EMs) entered the financial vernacular in the early 1980s as a way to describe countries that were rapidly becoming industrialized. In 1987 the MSCI Emerging Markets Index opened doors to investing in places like Brazil, China, India and Russia (the so-called “BRIC” nations), along with some 20 other developing countries including Vietnam, South Africa and Colombia. Lured by a potentially supercharged market opportunity, investors jumped in.
At the time, a new concept called globalization was also emerging. Globalization supported EM development through integrated global supply chains, cross-border trade, and opportunities to invest in high-demand commodities essential to growth. Though widely promoted by some participants as a way to develop markets and raise standards of living, globalization was derided by others as a tool for exploiting poorer, weaker economies and natural resources.
The MSCI Emerging Markets Index handily outperformed the S&P 500 for a long stretch, returning 15.22% versus 12.16% from January 1988 through December 2006. Returns were not evenly paced, however. While some months produced blockbuster returns, many more were flat or down, reinforcing the inherent risk of investing in EMs. Among those risks: self-serving state-run enterprises, a lack of transparency, unstable political situations, currency volatility and debt default.
The Great Recession put the skids on global investment and hit EMs especially hard. But more than a decade has passed since then, and the sector continues to languish. Pundits have varying explanations. Some believe the very idea of “emerging markets” has run its course as the world enters an era of nationalism and anti-globalization. Others say investors would be foolish to leave the table. Let’s take a closer look.
The Convergence Fallacy
One assumption about investing in EMs is that they grow faster than developed countries, simultaneously creating new investment opportunities as they mature and “converge” with developed economies. These assumptions have been sharply questioned as global growth slows.
As Jonathan Wheatley writes in the London Times (15-July 2019), “…convergence is no longer assured. Today, high commodity prices are a fading memory. Trade is sputtering and global supply chains are being disrupted. Far from catching up with the developed world, many supposedly emerging markets are growing more slowly.”
Wheatley and others see multiple ongoing threats to emerging markets, including a globalization backlash, a slowdown in China’s growth, and tightening global financial conditions.
Trade wars launched by Donald Trump have led the wave of anti-globalization sentiment. After bluffs, failed negotiations and no resolution in sight, markets have become volatile as protectionism puts the brakes on free trade around the world. From clothing to cars, tariffs add a stiff tax and reduce business investment and consumer demand. As growth slows, demand for commodities slackens and prices fall, creating another economic hit on EMs.
Global warming and climate change are also creating unprecedented challenges for EMs, which are collectively poised to surpass developed nations for harmful emissions. Many emerging economies in the southern hemisphere, including India and Vietnam, are at high risk of extreme climate change impacts. This could create significant disruption in their economies and challenge growth in other unforeseen ways.
At a macro level, two of the trends that supported EM investment—exports and consumption—are shifting. A core driver of investment in EM countries is that they would export more goods, in turn creating new trading opportunities around the world. But in recent years, China (the largest EM economy) has become a more consumption-oriented economy. This has affected multiple trading partners as China buys less steel, concrete, bricks, and other raw materials from external sources. “The US-China spat has exposed the vulnerabilities of export-orientated economies in many emerging markets,” writes the Financial Times Editorial Board (25-July 2019), adding that this has “disrupted supply chains across Asia and emerging market commodity exporters.” Some lower-income countries have benefited, but not many.
Added to this deep uncertainty is the fact that many EM countries did not take advantage of boom times to make the necessary structural, financial, technological and social changes required to weather a global recession or to create self-supporting economies. As foreign investment falls, “this is where I start to worry about emerging markets in a fundamental way,” Robin Brooks of the Institute for International Finance told the Financial Times. What happens, he wonders, when the wave of manufacturing that moved to emerging markets pulls back? “That wave has run its course,” he says.
A Different Perspective
If you want to pull out of EM investing, you’re not alone. Hedge funds, multinational corporations and private investors are doing it. But before you do, consider that the tide will change. It always does.
Our current climate of nationalism, populism, trade wars and tit-for-tat retaliation is not likely to last. Why? Because it will deeply damage our own (US) economic interests. We live in a truly global economy where the actions or reactions of one country can launch negative ripple effects throughout the world. There’s too much at stake to let this happen, including, in the political realm, the risk of a recession in an election year. In the short run, politics may be driving economics, but longer term, policymakers have the tools to ratchet down tension and contain the damage.
Seventy-five years ago a new world economic order took shape at Bretton Woods, where the argument for international cooperation was motivated in part by the destructive horror of World War II and also by “The belief in a common interest in international cooperation, the importance of certain basic rules of good behavior with respect to exchange rates, and the need for development among the multitude of ‘emerging’ nations.” Those are the words of former Fed Chairman Paul Volcker in a new book, Revitalizing the Spirit of Bretton Woods, a collection of essays on what global cooperation looked like then and now.
Today this cooperative international spirit is deeply diminished. Nations that worked together are turning inward to serve their own perceived best interests. The ripple effect is already clear. China is the largest contributor to total EM output, and its actions are hurting trading partners. Likewise, the US is hurting some of its closest allies and trading partners, including Mexico and Canada. Slapping punitive tariffs on other countries, manipulating currencies, and instituting protectionist measures won’t work without inflicting damage that can spread well beyond perceived antagonists. The harm is evident in slowing productivity, disrupted trade, higher prices for consumers, and most especially the lack of cooperation on urgent issues like climate change.
Surprising Facts for Investors
As an investor, let’s assume it’s better to be hard-headed than soft-hearted. You are primarily concerned with the growth of your money. I’ll give you four good reasons to retain a position in EMs.
Exposure. EM and frontier markets (smaller, much higher risk) now account for approximately 12% of global equities, up from 2% in 1980 (source: London Business School Review). Given the random and unpredictable nature of equity performance, it would be foolish to ignore this sector entirely.
Performance and Diversification. Don’t judge EM performance over a decade (“recency bias”). Judge it long-term. The numbers may surprise you.
Consider how a diversified portfolio holding 80% S&P 500 Index and 20% MSCI EM Index performed over the past 31 years, from January 1988 through 2018 (the MSCI EM Index first reported data in 1988, which is why we start there).
Over this 31-year period, it certainly hasn’t been a smooth ride for Emerging Market investors but the MSCI EM Index did outperform the S&P 500 Index, returning an annualized 10.42% vs 10.18%, respectively. And since the asset classes are somewhat uncorrelated a diversified allocation 80% S&P 500 Index and 20% EM Index did even better, returning a combined 10.48% with the same risk profile as 100% allocated to the S&P 500 Index.
• In 1991, the S&P 500 returned 30.47%, while the MSCI EM Index nearly doubled that at 59.91%.
• In 1997, the S&P 500 returned 33.36% while the MSCI EM Index returned negative -11.59%.
• In 2017, EMs outperformed the S&P 500, 37.75% to 21.83%.
• in 2018, the pendulum swung again, with EMs returning negative -14.24% to the S&P’s negative -4.38%.
Two points here: Emerging markets provide diversification, but like all other equities, it’s impossible to time EM performance. The MSCI EM Index is more volatile than the S&P, but if you miss just a few of the best years or best months, you can’t reap the cumulative total returns. The odds of capturing the benefits increase with a longer holding period.
Valuation. In terms of earnings, while U.S valuations remain relatively high, EM valuations are near rock-bottom levels. According to asset pricing theory, paying a lower price for beaten down equities should result in better long-term returns. The current period of protectionism is not likely to last. Recall 1980, when Ronald Reagan declared “Japan is part of the problem” and later imposed 100% tariffs on certain Japanese electronic products. By 1987, the US had swung in a different direction, supporting free trade agreements and economic cooperation throughout the developing world.
Random Country Performance. Some believe it’s fine to invest in EMs if you selectively choose the safest countries. But what’s safe today could implode tomorrow. Between January 1999 and December 2018 (19 years), the MSCI Emerging Markets Index as a whole returned an annualized 8.52%. Within the index, performance ranged from an annualized negative -13.57% for Greece to 16.41% for Peru. Would you have singled out Peru as the best performer for the period? For comparison, China underperformed the index as a whole with an annualized return of 6.97% (all data net dividends).
I would not argue that investors should hold a substantial EM position. But I would suggest that a small EM position, perhaps reflective of overall market valuation, should be part of most portfolios. Since its inception as a portfolio index investment, EMs have expanded and contracted many times, often very rapidly. Nonetheless, the MSCI EM Index outperformed the S&P 500 Index over the total span of 31 years. You may never feel entirely comfortable with this sector, but you shouldn’t ignore it either.
Do you have questions or concerns? Call me, I am here to help.
Regards,
John Gorlow
President
Cardiff Park Advisors
888.332.2238 Toll Free
760.635.7526 Direct
jgorlow@cardiffpark.com