Emerging markets: Where the wild things are

Resetting preconceived expectations

“That very night in his room a forest grew…until the walls became the world.” It’s at this point in Maurice Sendak’s influential 1963 children’s book where young boy Max’s imagination takes over from reality and crosses into the realm of fantasy. Where the Wild Things Are has become required bed-time reading in this author’s household (at the repeated insistence of another active seven-year-old boy). Admittedly, we also never tire of the tale — perhaps because the book’s central themes also speak to adults: isolation; growth; and ultimately, connection with the outside world.

Investor imaginations have also run wild in emerging markets of late. Many now view Emerging Market (EM) countries as vulnerable to protectionism, contagion risks, and moderating growth. But this view simply extrapolates the EM experience of the 1980s and 1990s to the present. Both are mistakes. Most EM economies are far more shock-resistant than in the past, owing to a whole host of improving macroeconomic factors.

Not that any of this negativity is new. Regularly, EM assets fall in and out of favor. When markets tumble, the EM story suddenly darkens, with themes of danger, crisis, and other wild things. But, just as quickly, animal spirts – that colorful name the economist John Maynard Keynes gave to human overconfidence – can be revived. The outlook is wonderful again.

Looking back on last year, most media attention focused on the woes of Argentina and Turkey. But every year, some EM or frontier country will experience serious macroeconomic instability. Why superimpose the experience of a few idiosyncratic basket cases on an entire universe of more than 75 countries (many of which have solid fundamentals)?

The overall EM position is far more benign than a few outliers and certainly not every country is run by leaders such as Turkey’s President Recep Tayyip Erdoğan (no wallflower to be sure). For example, in the mid-1990s inflation rates above 20% were not uncommon. Today’s EM inflation is trending below 3.5%. The list of improving factors is lengthy: the emergence of domestic pension systems (which reduces reliance on foreign funding); improved trade balances; better fiscal positions; and a number of other strong secular growth drivers.

What about EM valuations? Here, more good news exists. EM stocks trade at a hefty discount to their developed-market peers (based on price/forward earnings). EM debt also presents good value, offering higher yields than the U.S. high yield space with arguably less risk. And EM currencies can only be described as a “deep value” play. Remarkably, EM nominal exchange rates are roughly 30% lower than during the 2008 global financial crisis.

Where to next? History shows that EM outperformance cycles typically unfold over several years. The last eight years of EM underperformance (for the period ending in 2016) were preceded by nearly nine years of outperformance. Furthermore, EMs already had a large slowdown between 2010 and 2016. Since then, currencies have weakened (boosting competitiveness), and policy has turned stimulative (lowering the cost of capital). These benefits always show up with a lag. Why should this time be different?

Investment implications

“Childhood is a tricky business,” Sendak once said. “Usually, something goes wrong.” So it is in emerging markets. Any long-term commitment to emerging market equities will be a journey filled with blustery retracements, corrections, and the unexpected.

But with higher volatility comes higher returns. Emerging markets are more dynamic compared with developed markets because of the diverse nature of their political and capital market development. That means there is significant room for active country, sector, and thematic selection. Within this analysis, “top-down” perspectives are crucial, as they tend to dominate “bottom-up” stock drivers.

But investors collectively have not focused on country-specific macro factors when investing in emerging markets. Rather, these countries are lumped together as a static group of homogenous markets carrying the single banner of “EM.” For example, the famed BRIC group of countries – Brazil, Russia, India, and China – in fact have drastically different macro profiles. Their positions in the commodity supply chain and respective current account situations could not be more dissimilar.

China and India are both net commodity importers, but China runs a chronic current account surplus while India has been in chronic deficit. Brazil and Russia are net commodity exporters, but the former runs a current account deficit while the latter is in surplus. Indeed, no four other EM countries are more different than the BRIC countries. Nonetheless, numerous ETFs have been established to invest in BRIC countries and EM bourses in general. These passive “acronym investors” (as Alpine Macro calls them) strictly follow country weightings according to the indexes without differentiating macro drivers for each country.

Additionally, EMs previously were all about commodities and cyclical investments. No more. Today, some 41.6% of the MSCI Emerging Market index is made up of “structural growth drivers” such as communications, technology, consumer, and healthcare companies. Overall, the tech share of the EM market is higher than that of the S&P 500. Conversely, the materials component has fallen to a mere 7.7%. This should make investing in EM far less cyclical than the past.

To be sure, investing in EM equities over the past seven years has not been easy. Today’s EM equity index is still materially lower than its April 2011, post-global financial crisis peak, and has underperformed its developed market counterpart by approximately half. After a prolonged bear market, investors are looking at EM stocks through decisively skeptical lenses, despite their ever-widening valuation discount to the developed world.

However, the higher long-term returns will be worthwhile – especially so seen in the context of a balanced and broadly-diversified portfolio. Growth in developed economies is forecast to stagnate in the coming years while emerging market growth is expected to accelerate. By 2035, it is estimated that emerging market countries such as Russia, Brazil, India, China, and others will represent 60% of world economic activity, up from 38% (as of the end of 2017). A coming surge of emerging-market citizens of labor force age will drive much of that growth. In a growth-scarce world, investors would do well to reset their opinions of emerging markets.

Tyler Mordy, CFA, is President and CIO for Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. He specializes in global investment strategy and ETF trends. This article first appeared in Forstrong’s publication Super Trends and Tactical Views, available on the Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.

Notes and Disclaimers

The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.