July 17, 2018 glacierinvest

Emerging markets (“EM”) are becoming increasingly topical as they continue to underperform their developed market peers. The concoction of tightening monetary policy in the US, a rising U.S. dollar (“USD”) and general uncertainty about the global economy (trade wars and volatile commodity prices) have proven insurmountable for EM stocks in 2018 so far.

Relative to U.S. stocks, EM stocks, collectively, are at their lowest performance point in the past 13 years, using the ratio of ETF prices between EEM and VTI. Please note, this is a performance metric not a valuation metric.

Looking at a similar metric, we observe EM stocks have performed much better against developed markets ex the U.S. (“DM”).

Relative to the USD, EM stocks don’t look bad at all right now. In other words, it could still get a lot worse from here relative to the USD.

A few takeaways:

  1. Larger allocations to EM relative to DM may be warranted for investors with long time horizons. Demographic and growth profiles tend to be much more favorable in EM than in DM.
  2. If USD keeps strengthening, EM stocks potentially still have a lot further to fall.
  3. The above charts don’t really answer the question of whether EM stocks are cheap or not.

As we mentioned in #1 above, many emerging markets have a lot going for them in the form of favorable demographic and growth profiles. However, there are many EM that are highly dependent on the USD, which is never a good place to be in when the Federal Reserve is tightening monetary policy. And it’s actually a double whammy this time as the Fed is not only raising rates but it’s also allowing the fixed income securities it purchased as part of its quantitative easing efforts to mature. In other words, it’s removing USD from circulation after injecting trillions of USD into circulation.

Not All EM are Created Equally

For those countries that have a lot of debt denominated in USD and large current account deficits, it’s likely going to be a rough ride for the foreseeable future. While on the other hand, those countries that aren’t as dependent on USD and have manageable current account deficits will likely fare better although it probably won’t be a fun ride regardless.

In summary:

  1. With an ongoing declining supply of USD it’s likely EM are going to go through a tough stretch for the foreseeable future.
  2. Countries that are less dependent on the USD and commodities (oil) with manageable current account deficits will likely fare best.
  3. Increasing allocations to EM relative to DM may make sense over a long time horizon given their more favorable demographic and growth profiles as well as their generally more attractive valuations.

One point of caution though. Now is probably not the right time to be increasing allocations to EM given the broader secular trends we’ve discussed in this post, not to mention the group as a whole broke trend in May.