Emerging Markets – Don’t Panic Captain Mainwaring

Date Published: 3 July 2018

Category: Investment

In this blog, I’m writing about Emerging Markets – shares and bonds, but before you decide it’s all doom and gloom – 3 thoughts to consider when reading my full blog:  

  • As Warren Buffett said, it is wise to be “Fearful when others are greedy and greedy when others are fearful.” 
  • When EM equities have been as cheap as this vs world equities, the returns over the next 12m has averaged 25.0% in USD (as compared to an average gain from World Equities of 15.6%).   
  • Over the last 10 years to end June 2018, world equities have delivered far superior returns to emerging equities (99.8% vs 34.4% in USD), but at times when Emerging Market equities have been as lowly valued as they are today, they have beaten world equities 67% of the time based on our research.

As I scan articles and commentary I observe an overwhelming panic by investors on anything relating to emerging markets be it shares or bonds: 

MXEF Index (MSCI Emerging Markets Index)

JPEIGLBL Index (J.P. Morgan EMBI Global Total Return Index)

Source: Bloomberg

Recently there have been significant outflows from both EM bonds and shares.  EM bond funds have seen the 10th week in a row of outflows over the week ending June 27, according to Jefferies calculations based on EPFR Global data. EM Equities have also seen large redemptions.  The chart below shows the net flows in and out of the $30.8 Bn iShares MSCI Emerging Markets ETF and highlights the latest outflows as being one of the highest periods for five years:

EEM US Equity (iShares MSCI Emerging Markets ETF) Price

EEM US Equity (iShares MSCI Emerging Markets ETF) Money Flow

Source: Bloomberg

It’s easy to see why investors have hit the panic button.  Recent headlines about US/China trade war, the likely rises in US interest rates (making EM yields slightly less competitive), and the problems with Argentina and Turkey.

It’s not just EM bonds and shares that have been hit, so have many of the EM currencies – recently the Indian rupee traded at a record low against the US dollar.

So, even though it looks like bad news all round, there are two main aspects of this panic which should give investors comfort.  One relates to perspective and the other valuation.  Basically, the serious issues from these headlines relate to only a part of the EM world and the valuations are now approaching their lowest level for five years, so arguably already incorporates much of the downside / bad news.

  1. Perspective

There are substantial differences between individual EM markets – the table below compares the five largest countries within the iShares J.P. Morgan $ EM Bond UCITS ETF (Mexico, Indonesia, Turkey, China and Russia) with the five largest countries within the iShares Global Govt Bond UCITS ETF (US, Japan, France, Italy and Germany).

You can see, some countries have their issues e.g.  Turkey operates a significant current account deficit, whilst China has significant exposure to “shadow banking” that means it’s true debt exposure is much greater than the headline numbers.  In contrast, Russia is benefitting from a rising oil price, has little external debt, high FX surplus and a large account surplus.

However, whilst there are significant differences from country to country, a typical EM bond even when denominated in USD rather than their local currency, yields nearly 4x a typical developed market bond and operates in a country with a similar budget deficit, but much higher real GDP growth and a much lower level of debt to finance (except in China).

*The PBOC, the central bank, supports significant lending activities within China via “shadow banking”.  China Total Debt, which includes corporate debt, was 266% of GDP as of 31st December 2017.

Source: Bloomberg

  1. Valuations

EM stocks are comparatively cheap when measured by the P/E based on rolling 10-year periods (i.e. like the CAPE ratio), their price-to-book ratio, price-to-sales ratio, dividend yields etc.

Yet, fear around emerging markets seems even more pronounced than at the early 2016 EM lows.

Source: Bloomberg

We looked at monthly data over the last 10 years, analysing each month where the P/E ratio of emerging markets stocks as against world stocks has been as low as it is today.

Interestingly over the 10 years to end June 2018, emerging market stocks have massively underperformed world stocks with a return of 34.4% against 99.8% in USD for world stocks, thanks to the huge performance of US stocks (which rose by 165% over this period).

There have been 42 months out of the 120 months (10 years) in which emerging stocks have been as cheap as they are today in terms of their P/E ratio. Had you bought emerging market stocks at one of those periods, your average return over the next 12 months was 25.0% vs 15.6% for world stocks.  In more than 2/3rd of the time you were better off in Emerging Market stocks over the next 12 months.

Of course, we are not predicting that these very high absolute returns will be repeated but we do believe the returns will be higher from EM shares from here.  Research Affiliates have modelled various asset expected returns based on valuations and their latest forecast shows in USD, Emerging Markets compounding at 8.5% pa with a 65% chance of a 5%-real return (Data as of 31st May 2018).

This compares with a return of little more than half of this, 4.8% pa from World equities with just a 16% probability of a 5%-real return.

Source: Research Affiliates

Sometimes it’s better to make decisions using brainpower rather than emotion.  Now is that time.

Please Note

Image attribution  – Link

The value of investments can go down in value as well as up, so you could get back less than you invest. Exchange rates may cause the value of overseas investments and income from them to rise and fall. It is therefore important that you understand the past performance is not a guide to future returns. SCM Direct does not give personal advice.

SCM Direct is a trading name of SCM Private LLP which is authorised and regulated by the Financial Conduct Authority to conduct investment business.  Company registered in England and Wales, no. OC342778.

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