26 April 2018
Emerging diversification
Don’t avoid emerging markets just because of volatility.
by Frank O’Nomics.
Conventional wisdom suggests that when developed markets sneeze emerging markets catch a cold. The area of high growth that flourishes during periods of steady global progress should be avoided when a downturn threatens. That has tended to be the maxim. If imminent trade wars and slower Chinese growth are coming to the fore, surely we should be selling emerging market stocks and buying blue chips in the developed world.
Such a view may have been viable twenty years ago, when emerging markets were heavily dependent on commodities, but ignores the extent to which they have progressed rapidly into other sectors and now provide, not only the engine of future growth, but also a healthy source of diversification for our portfolios.
After a bull run that saw it almost double in the 2 years to the end of January, the MSCI Emerging Markets Index gave over up a tenth of its value to a point this week where it was back to where it started the year. The most recent drivers of the correction were US bond yields and the US dollar, both of which saw appreciable rises, the latter leaving the EM currency index at a four-month low. This is a double whammy as a higher US yields make EM assets look relatively less attractive and a stronger dollar is painful for overseas borrowers with dollar-denominated debt. However, while the short-term outlook for EM looks questionable, the setback may be regarded as an opportunity to enter an area that offers high potential growth at a time when most asset classes are very fully valued.
While there may be scope for the US equity markets to continue to make progress, particularly given recent tax cuts, they must be coming close to the end of a cycle that has been running for a long time. When it comes to EM the prospective return on equity and the price-to-book ratio makes them look much more interesting – EM are currently valued at around a 25% discount to forward earnings, compared to a long-term average of 20%. The case is further supported by fund flows, with institutional investors still not having fully closed underweight positions that were opened the last time they became faint-hearted in 2013-14. These underweight positions are however rapidly being closed, with $43bn being attracted into EM equities in the first quarter, and a whopping $3.7bn just last week.
What investors seem to have missed is that emerging markets have come a long way since the 1980’s, when they were dominated by commodities and very correlated with risk tolerance. In fact EM indices are now as diversified as developed markets, with a significant exposure to financials and IT, while commodities now have a lower weighting in the MSCI EM index than tech stocks. Within EM there is a huge difference of sector emphasis across geographies. There is little comparison between India, which has become very focused on service industries (23% financials and 16% IT in the ishares ETF), Brazil which still has a high proportion of commodity stocks (less than 2% IT), and China, which is shifting from manufacturing towards services (almost 50% of the large cap ETF is in financials).
With such a wide range of sectors you might argue that there is no point taking the additional risk of moving from more politically stable developed markets, given that they offer that same range. However, over longer holding periods emerging markets are still only marginally correlated with developed markets. Over one month that correlation is around 65%, but when one looks out over a year that correlation falls to 32% and in a 3-year comparison it is less than 5%. For the long-term investor such diversification can be very attractive, particularly in such uncertain times. There will be those that are concerned, especially after this week’s moves, about EM currency volatility and the costs of hedging currency exposure. These concerns have some weight but ignore the benefits of the additional source of return that FX can generate, and the fact that spikes in more volatile currencies can provide us with attractive entry points.
In the near term it is fully understandable that investors will be wary of increasing exposure to Russia given the impact of sanctions, and to China until the trade war outlook is clarified. However, China has done much to correct the overheating that had been apparent in its economy and elsewhere, particularly in the rest of Asia where earnings growth looks particularly strong, the outlook seems much more encouraging. The bottom line is, if you are bullish about global growth (and most economic commentators still are) then you should be still more bullish regarding those markets that are not over-valued and are in the areas that have the greatest scope to grow. Variety is the spice of life and portfolio diversification into emerging markets may be the spice of returns.
