Why Emerging Markets Now?

Written by: Matt Lloyd | Advisor Asset Management

While uncertainty has never had as much fanfare as it does now, leaning into it seems absurd to the average investor.

In a constant search to seek out a more optimized risk/return balance, the current state of the U.S. dollar, the interest rate differentials and GDP growth seem to be pointing to Emerging Markets for those seeking the proper balance.

Since the beginning of the year the trading range of the U.S. dollar has been extremely volatile. At the peak market panic of the last two weeks of March, the U.S. dollar was up 6.61%. Since then it is down 7.12%, which represents several changes. First, the global fiscal and monetary response was massive (we will detail this in our second half outlook for economic and equities next week) and nearly instantaneous. Historically, the response seen by central banks and governments are extremely lagging as witnessed in the Great Recession. As such, there was a belief that the current economic cost has been mitigated by a large amount of stimulus, with even more currently being discussed. The U.S. dollar is the dominant choice for transactions with an estimated 88% of all Foreign Exchange transactions in 2019. For this measure, remember there are two paired currencies in a transaction so the total of the transactions will be 200% (two times the 100% of all transactions) and not the 100%. According to the analysis done by the Triennial Survey of Forex Exchange as referenced in an article by John D’Antona Jr. for Traders Magazine January 24, 2020 “88% of all 2019 Forex Transactions Are in U.S. dollars” and Emerging Markets transactions totaled 25% of all transactions with the Chinese renminbi as stable, but the currencies in India, Indonesia and Korea all were increased. During the first quarter of 2020, the Emerging Market Currency Index, as quoted by JP Morgan, was down 14.58% but has recovered a little over 6% since that bottom. The currency component is a vital aspect to allocating to the international markets but also when confirmation comes from other areas.

Another component is the cross-interest rate differentials which has set a new high. For generic purposes, monitoring the 10-year rate differentials between China and the United States is a simplistic, but effective, proxy in the last decade.

The only time that the spread reached the current level was September 2011. Over the last 10 years, the MSCI China Index has had an average annualized return of 5.68% and the MSCI Emerging Market Index averaged 3.29%. The period when the spreads reached the current level marked a tremendous entry point into both the MSCI China and MSCI Emerging Market area as denoted by the average analyzed returns from September 2011.

 

Another component is the elevated GDP growth of the Emerging Markets and Developing Countries relative to the G7 (The Group of Seven: Canada, France, Germany, Italy, Japan, the United Kingdom and the United States). An immense gap has again presented itself in which the G7 is going to stagnate far greater than the Emerging Markets based on IMF (International Monetary Fund) estimates.

The average excess growth of Emerging Markets and Developing countries has been 2.8%, while the current gap expected for 2020 is 5.1%.

One area that some consider a warning is the supply chains being brought back to the G7 countries, however, that will require a large amount of capital, government incentives and time. What appears to be the next course in this discussion is a diversification of the supply chain where the lower manufacturing wages in areas such as Thailand and India will offset the shifting costs. There may be an increase in secondary or back-up supply chains being brought back but this will require legislation much like what was introduced in Japan.

And lastly, consider some of the fundamentals of the Emerging Markets as measured by MSCI per Bloomberg.

  • Trading at 13.18 times next year’s earnings
  • 1.73x book value
  • Price to Sales of 1.42x

Emerging Markets have underperformed relative to the U.S. equity markets and currently stand at historically attractive valuations. We would use the uncertainty to allocate to emerging markets with the purpose of rebalancing risk/reward scenarios currently found in the larger economies.

Related: Looking Past the Pandemic at Emerging-Market Equities