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Wealth & Pension Services GroupMatt B. Bailey, CFA - Portfolio Manager06/09/14
Emerging Markets: Growth Opportunity or Value Trap?
After a lackluster 2013 and a rough start to 2014, Emerging Market (EM) equities as represented by the MSCI Emerging Market Index have rebounded nicely. As of May 31st, 2014, the index had returned 3.78% for the year and is currently up over 10% from the lows seen in February.
These positive returns have garnered investor attention. The latest flow data from Morningstar reveals that Diversified Emerging Market mutual funds saw a $2.94 billion net positive in-flow during the first quarter of this year and over $26b for the 1-year period ending March 31st. Additionally, the Wall Street Journal recently reported that EM mutual funds and ETF’s took in just over $13b during April and May of this year.
Many readers are probably asking themselves, “Why are the Emerging Markets suddenly attracting so much attention after such a long period of relatively muted performance?” This is a great question with a few possible answers.
First, it’s important to address some potential reasons why the Emerging Markets have not performed as well over the last few years. Many investors have pointed to the strong performance of the US markets as the main culprit to why EM has lagged. This chart shows the positive returns experienced by the US equity markets going back to 2009. Over the past 3-5 years, the US has continuously been referred to as “the cleanest dirty shirt”. This perception, that the US markets offered the least amount of risk relative to the rest of the world has led to significant capital inflows and price appreciation since 2009.
Other explanations for the relative underperformance include: waning demand for commodities, lack of new investment flows and poor central bank policy. Many Emerging Market countries are net exporters of raw commodities such as oil and industrial metals and depend on global demand of these materials to support their economies. Since the financial crisis in 2008, the global demand and prices of many commodities have been well below what was seen during the previous decade. Furthermore, many Emerging Market countries began experiencing decreased liquidity and capital outflows over the last few years as many developed market economies started recovering and provided more attractive risk-adjusted returns.
The two previous themes, coupled with the fact that several EM countries have struggled to contain their large current account deficits, has led many to question their economic stability. Finally, the US Federal Reserve’s announcement last summer to start scaling back their quantitative easing program caused many investors to continue underweighting or even avoid the Emerging Markets altogether. The rationale being that real rates in the US were likely to start normalizing to higher levels and this shift would cause EM yields to look less attractive and result in capital outflows.
Currently, many EM countries have started addressing these issues by raising short-term interest rates in hopes of strengthening their currencies against the US dollar. Multiple countries have also started electing pro-growth leaders in hopes of implementing positive regulatory reforms that support growth.
Emerging markets offer access to a burgeoning middle-class that is growing at rates much higher than those seen in developed countries. According to a recent report by JP Morgan, the Emerging Markets as a group make up a significant share of global GDP at roughly 50% as seen in this chart. Additionally, as the global economy continues to heal, it is possible that global demand for commodities will increase and thus put upward pressure on prices. This would benefit many EM countries whose economies are heavily dependent on commodity exports.
Lastly, many financial pundits have begun noting that a number of developed equity markets are close to fair value at their current levels. Although the Emerging Markets aren’t cheap, many experts have suggested that they are priced to offer significantly more value than their developed market counterparts. As of 3/31/2014, investment group Research Affiliates noted that the Shiller P/E for EM stood at 14.0, compared to 25.2 and 15.9 for the US and EAFE markets respectively. This chart compares each equity market at it's current valuation to that of it's average valuation during both growth and recessionary periods.
In conclusion, the Emerging Markets are by no means a safe bet but do offer a compelling story. As a firm, we have continued to allocate capital to them in our portfolios and believe they have positive growth prospects. With that being said, it is very important to understand that each country is unique and carries its own risks. We think investors should allocate capital to the EM space through the use of actively managed investment strategies that are run by experienced investment managers. Finally, because the Emerging Markets can be volatile, it’s paramount that investors consider all the potential risks and take a long-term approach when allocating money to them within a portfolio.
Source: Morningstar, WSJ.com, Leuthold Group, JP Morgan, IMF, Research Affiliates, Robert Shiller
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