Here’s a stunning fact: Since the start of the year, the S&P index of US stocks has outperformed its emerging market counterpart by a full 15 percentage points. With such divergence, and with last week’s focus on the headwinds facing the S&P, long-term investors may feel tempted to shift their asset allocations toward emerging market equities and currencies in search of growth potential.
But best look closely at the underlying drivers first before acting on this temptation in any meaningful size.
The extent of this year’s outperformance of the S&P over EEM — the iShares MSCI Emerging Markets ETF — pales in comparison to what has happened over a longer time period. Since end-December 2012, the S&P is up about 105 per cent while EEM has fallen more than 10 per cent.
At odds with long-held views
Such divergence contrasts strongly with two widely cited hypotheses — that of long-term economic and financial convergence between advanced and developing countries, and of the impact on asset prices of all the liquidity created by central banks in advanced economies (particularly the European Central Bank, the Federal Reserve and the Bank of Japan) being particularly notable as it flows down to the smaller financial markets of the emerging world.
Not all slices of emerging markets felt the same effects. Indices of sovereign bonds issued in dollars and other foreign currencies suffered the least, while those with domestic equity and currency exposures have been hit quite hard.
Having sold off to such an extreme, the most underperforming segments of emerging markets now look attractive on a range of historical comparison metrics. And, certainly, one cannot rule out the likelihood of price surges for an asset class that, historically, has consistently overshot both on the way up and on the way down. Yet three large forces will temper that likelihood.
* First, there is no easy way for most emerging economies to quickly offset the persistently detrimental effects of a slowing advanced world and protracted trade tensions. Even the most agile of them (e.g. Singapore) face growth challenges as they also tend to be the most open economies.
As such, they are likely to face in the short-term lower global demand and less favourable terms of trade, as well as uneven foreign direct investments.
* Second, many of them are limited in their domestic policy responses, also exposing them to political and social pressures. With already lagging structural and institutional reforms, the cost-benefit of short-term stimulus measures is far from favourable.
At the same time, unless forced by a financial crisis, the needed long-term adjustment measures will appear to imply larger shorter-term costs than many political systems will be willing to tolerate. With that, the most likely outcome is delayed policy responses and an increasing number of countries facing bouts of financial instability.
* Third, there are still “tourist funds” trapped in the asset class that are likely to look to exit on any significant price bounce. The dedicated investor base is still not as yet big enough to compensate for such exits in a quick and orderly manner.
This is not to say that there are no longer-term opportunities. The time will come for allocating generally to emerging markets, including through broad indices, ETFs and other passive products.
For buy-and-hold investors, however, we are not there yet. Much better for them to focus on the narrower, highly differentiated portfolio approaches.