What’s Going on in Emerging Markets?
After 2017, a year in which emerging markets gained more than 35%, investors are very concerned about the performance in 2018. Year-to-date, emerging markets are down nearly 8%. If valuations in the space are at multi-decade lows, what can explain this seeming discrepancy? It turns out there are several factors contributing to weak performance so far this year. First, although it is easy to assume it has little effect, the US dollar has strengthened significantly in 2018. In local EM currency terms, the dollar has rallied nearly 10% in some instances (compared to 4% in dollar terms). Some of these countries (e.g., Turkey, Argentina, and others) are actually seeing bear market territory for their securities in US dollar terms. Emerging markets tend to underperform historically when the US dollar gains strength.
The next factor is the move towards protectionist policies on an international scale, and in particular, by the US. Further exacerbating the situation, Trump, has instituted a non-systematic trade war with multiple countries, some of which are emerging market economies. As an example, Trump has targeted Turkey which is a key EM economy and is intricately connected to many other emerging market economies in the vicinity. The threat of tariffs has had a detrimental impact on EM economies that sell to the US (i.e., EM exports will decrease causing an increase in unemployment in these countries).
A third factor is the rebound in commodities, particularly oil. If you look at current oil prices (Brent, WTI) compared to last year over the same time, oil has moved nearly 50% higher. This has a more negative impact on emerging markets because it makes manufacturing costs higher.
Although the above points paint a not-so-rosy outlook on emerging markets as an asset class, many emerging market economies have improved their current account deficits and strengthened their overall financial position. It is also important to view EM in a worldwide context. From a CAPE (cyclically adjusted price earnings) perspective, emerging market countries are poised to outpace the rest of the world over the next 10 to 15 years. The United States has had its longest bull market in history, and prices haven’t yet receded. The last recession in the US ended in June 2009. This means the US is on its nearly 37th quarter (111th month) without a recession. With the average economic cycle lasting between 5 – 7 years, the US is poised not only for a recession, but its equity market has and continues to be highly, if not, fully valued with a CAPE near 40%.
From a long-term investment view, attempting to call the top of the US market (or the low of emerging markets, for that matter) is a fool’s errand, likely amounting to nothing more than a blip over the long haul. As history and academia teach us, it’s very important to never attempt to time markets; it is a losing proposition. Where we are in the current business cycle is no different. Emerging markets remain an important part of a global asset allocation strategy, but investors must expect higher than average volatility in this asset class since it is less stable than other developed markets.