Dave Donabedian, CFA
August 21, 2018
Most headlines related to emerging markets (EM) have been decidedly negative this year. The growing U.S. trade conflict with China (by far the biggest emerging economy) helped spark a bear-market-sized decline in the Shanghai Composite Stock Market Index over the last seven months.1 More recently, the economic and financial travails of Turkey have rippled through global equity, bond and currency markets, but with a particularly negative impact on other emerging markets. After stellar returns in 2017, EM equities have lagged this year:
Despite the challenging environment, the CIBC Private Wealth Management Asset Allocation Committee (the Committee) recently upgraded its assessment of EM equities for the intermediate and long term, particularly relative to the developed international markets. The Committee does not recommend an overall increase in stock market allocations, but rather a review of the mix between developed international (e.g. Europe and Japan) and emerging market equities. As described below, the Committee also recommends that the vast majority of EM country allocations be focused on Asia.
The Case for EM versus Europe/Japan
With a multi-year view, we believe relative performance prospects for EM have improved due to:
From its cyclical high in late January, the MSCI EM Index has dropped 20%—right on the verge of bear market territory.2 Most EM country returns have lagged in local currency terms, and most EM currencies have deflated vs. the dollar, euro and yen. This “double whammy” has produced an attractive relative valuation factor in favor of EMs. The first chart below reflects that the price-to-earnings (P/E) ratio on the MSCI EM Index has dropped to below average relative to the developed market EAFE Index. The second chart shows that the drop in EM has pushed the P/E ratio to less than 11x—back to where it was 2½ years ago.
The long-term case for EM is superior growth of both economies and profits due to rising global competitiveness and accelerating development of the middle class. As shown in the table below, both short- and long-term expectations for earnings growth are much higher for EM than Europe.
Meanwhile, last year’s accelerating growth story for Europe and Japan has faltered in 2018. Both economic and earnings growth expectations are being downgraded in those regions. Recession risk is fairly low, but these economies have settled back in to their very slow secular growth potential.
The Committee’s long-term return forecasts (a 10-year horizon) expect a significant premium to be earned in the emerging equity markets over the developed countries (e.g., U.S., Europe and Japan). Our tactical message is that the significant pullback in EM has provided an attractive entry point for investors with no emerging market exposure; or an opportunity to increase emerging market exposure funded by a reduction in foreign developed markets assets. The Committee recommends maintaining current allocations to U.S. equities.
Managing Short-Term Volatility
While the Committee believes the “more emerging/less developed” shift will be advantageous over time, emerging markets are not without risks—especially in the short term. Emerging markets have been acutely sensitive to the gathering conflict over global trade, especially as it becomes a showdown between the U.S. and China. Both rhetoric and action on this front are highly unpredictable, and may not yet have reached their maximum potential to inject volatility into markets. Given the importance of China as an export destination and economic partner for many EM, any economic fallout for the Chinese economy would likely have a ripple effect on emerging market earnings. Also, the U.S. dollar tends to strengthen when trade issues heat up, and that is traditionally a headwind for emerging market equity valuations.
The crisis in Turkey is another story. Turkey represents only a tiny fraction of emerging market equities, with a MSCI Index weight of less than 1% (China is over 30% of the index).3 However, Turkey’s economic predicament has caused a ripple effect throughout EM. Some of this is normal (if not rational) investor behavior in an uncertain time—shoot first, and ask questions later. But, there is also the memory of the “Asian contagion” of the late 1990’s—when what seemed like a single country’s problems (Thailand) caused persistent declines in other Asian economies and markets and in the U.S., as well.
Indeed, the Asian contagion was a major catalyst for reforms that make us less concerned about a contagion this time around; and, is a key reason why we believe a primary focus on Asian markets is the best strategy for participating in EM. In the 1990s, many emerging Asian economies financed their growth by borrowing from abroad, usually in the lending country’s currency. In some cases, the borrowing proved excessive, leading to a loss of confidence when interest rates rose and currencies fell vs. the dollar. Those countries learned from their mistakes, and have restructured to emphasize current account surpluses, less external financing and low inflation.
In recent years, Turkey has chosen the old Asian model, running large budget and trade deficits, and financing the gap with foreign denominated debt. Poor economic and central bank management led to a loss of confidence and a 40% decline in the value of the Turkish lira this year, making its foreign denominated debt much more expensive to repay. A diplomatic spat with the U.S. has heightened Turkey’s crisis. It is unclear how this situation will be resolved. It could well get worse before it gets better.
Regardless of what happens in Turkey, we believe in the near future investors will begin to realize that all emerging economies are not created equal, and that one should not view the EM as a monolithic bloc. We expect a decoupling in which countries that share Turkey’s problems (e.g. Argentina, South Africa and Columbia) continue to get punished, while economies built on firmer foundations will be viewed as growth opportunities. The table below highlights the differences in economic structure that exist within the emerging markets. Turkey and Argentina have wide trade and capital imbalances along with very high inflation and interest rates. China and South Korea run surpluses, rely much less on external funding and have low inflation and interest rates. Other than being in the same equity index, these pairings have virtually nothing in common with one another.
We cannot be sure when all of the macroeconomic and sentiment headwinds currently weighing on emerging market equity prices will be properly sorted out. At the same time, we know from experience that waiting for all of the headlines to resolve themselves is usually self-defeating. Markets tend to anticipate trend changes before they become front page news.
EM: Asia vs. Latin America
Within the EM category, the Committee recommends a significant emphasis on Asia. As discussed above, we view the Asian economies as generally better structured and managed than other regions, with consistent drivers of growth through productivity enhancement, rising living standards and improved corporate governance. While there are many high quality companies in Latin America and Central Europe, the economic and political backdrops are less supportive. This can be seen in the return profile below. Within EM, the defining difference in returns between Asia and Latin America has been currency. Latin American returns for a U.S. investor are consistently penalized by currency devaluations, whereas Asian currencies are typically correlated with the dollar, and are more stable.
CIBC Private Wealth Management’s Asset Allocation Committee recommendations express our views on directional portfolio shifts, driven by an assessment of relative risk and reward and do not take into consideration individual suitability requirements. At CIBC Private Wealth Management, asset allocation may be customized for each client, so a client’s particular portfolio allocation may not follow these recommendations. Some recommendations referenced may not be appropriate for your specific situation. You should consult with your financial advisor regarding your unique circumstances.
Dave Donabedian is chief investment officer of CIBC Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.
1Bloomberg, as of 08.17.2018.
2Bloomberg, as of 08.15.2018.
3MSCI, as of 07.31.2018.
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