How To Play A Rebound In EM Stocks
The emerging market asset class is testing investor resolve. With few exceptions, stocks and bonds of developing countries have provided negative total returns so far in 2018. The outlook for future returns, though, is better now that valuations have adjusted lower. It’s time to take a serious look at investing in emerging market equities. But why now, and what is the best way to get exposure?
Emerging market (“EM”) equity valuations are comparatively low compared to developed markets. According to Yardeni Research, the U.S. market trades at a 1-year forward price to earnings ratio of 16.3; the EM asset class trades at a multiple of 11.1 times earnings. Projected 2018 profit growth in both markets, after adjusting for the one-time corporate tax cut benefit, is similar between the U.S. and EM countries. Year-to-date, the return of the broad U.S. equity market ETF, VTI, is up 6.4%; the diversified EM ETF, VWO, has a negative total return of 6%. There are reasons for the underperformance. Trade tensions, the strength of USD, and heightened domestic political risk are higher than last year. These factors may cause additional near-term volatility, but should not impact the long-term prospects for the asset class.
Trade tensions are a legitimate concern, but should not be catastrophic for growth. According to a recent report for institutional clients published by JP Morgan, the recently proposed additional $200B of tariffs on Chinese imports are estimated to eventually shave a modest 0.25% off global growth. Not good, but not horrible either. Global supply chains will eventually adjust. And there is still the possibility that an off-ramp can be found, ending the escalation. EM stock prices have corrected lower and are now offered at a discount. If you like to shop on sale, now is the time.
As with any sale, lower prices do not always mean better value. There are legitimate reasons for the markdown in valuations in some EM countries. The damage is self-inflicted in the case of Turkey, for example. Turkey just reelected a president that feels compelled to control monetary policy, interfering with the independence of the central bank. Inflation is spiraling out of control, short-term bond yields are approaching 20% and the currency is plummeting. Investors in TUR, the iShares ETF that tracks a basket of Turkish stocks, are nursing losses of 28.4% year to date. But at 6 times price-to-earnings multiple, you might argue that the bad news is already priced into Turkish stocks.
On the other side of the world, the Chilean ETF (ECH) is down 10.4% this year. There is not an inflation problem. There is no threat to central bank independence. Short-term interest rates are low. The issue is a decline in metals prices. Chile’s major export is copper, and copper prices are tanking. China buys 50% of the world supply of copper, and anything negatively disrupting that demand is going to impact Chilean miners and the Chilean economy. Unlike the situation in Turkey, events outside of Chile are the primary cause for the equity market correction.
Each emerging market economy is different. Stock valuations in some countries are more influenced by domestic issues; valuations in other countries are more responsive to external macro drivers. When you invest in the equity market of a single country, you get exposure to a unique set of risk factors; global growth, regional growth, domestic politics, geopolitical stress, commodity prices– each with a different weight. The importance of each of these variable depends on a host of factors: domestic monetary policy, the level of external debt, positive or negative exposure to commodity prices, the dependence on trade, and the degree of political stability, to name a few. No two EM countries are the same.
If you want exposure to higher oil prices, buy Russia, not India (Russia is a net exporter of oil, India is an importer). If you want to benefit from a resolution in NAFTA talks, buy Mexico (Mexico is the EM country most leveraged to trade with the US. If you want to bet on a reversal in USD strength, buy Brazil (the Real has declined 14% relative to the USD so far in 2018.) When you invest in a single country, you isolate the performance drivers to one or two main risk factors.
If you don’t have a view on these macro variables, and just want exposure to global growth, buy everything. Don’t isolate your risk to a single country. Buy a market cap or fundamentally weighted ETF with an allocation to multiple countries across all major regions. If you want to make a bet on long-term global growth, don’t screw it up by buying an undiversified country ETF where global growth is not the main driver of return. There are many risks involved in investing in emerging markets. Don’t make lack of diversification one of them.