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Emerging Markets: A Return to Strength?
By: Jeffrey Barrow, CIMA®, Regional Director, Senior Consultant
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Emerging market equities have the potential to deliver high-flying returns with volatility commensurate for the wide-ranging number of risks present. We’ve all heard this and recent market performance confirms this pattern into 2017. Looking at traditional risk factors through 2017, one can identify drivers of current performance both for emerging market outperformers and those with challenging results halfway through the year.
Broadly, emerging market equities have enjoyed a significant performance advantage over developed market peers through the midpoint of 2017:
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Quite the reversal from the end of 2016, emerging market equities sold off sharply in the final three months of the year, while developed markets returned higher on the heels of President Trump’s November election victory which accounted for much of the sentiment in the markets. Thus far in 2017, investors appear to have shifted, resulting in the near-term reversal in these major markets.
While emerging markets enjoyed a relatively strong 2016 and an even better start to 2017, the recent past reflects a much more harsh environment. During the three year stretch of 2013-2015, the same MSCI Emerging Markets Index returned an annualized -6.4%3 per year. The subsequent 18-month period (1/1/2016-6/30/2017) yielded an annualized gain of 20.6%4. Return volatility, indeed!
Given recent strength, where are we today? Is there still value in these volatile markets? What are the unique risks investors must assess? To observe current stock market valuations over the last ten years, a measure known as the cyclically adjusted price-earnings (CAPE) ratio can be helpful, though the measure is certainly not the only data point to consult. The CAPE ratio uses the current price and the average of the last ten years of earnings, adjusted for inflation, to provide one snapshot of a specific market’s valuation as compared to other periods. Current major market CAPE ratios are revealing:
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| While only one statistic, the CAPE metric suggests there still may be longer-term value in emerging market countries presently. This supports DiMeo Schneider & Associates, L.L.C.’s 2017 Capital Market Assumptions in which we project emerging markets to have the highest 10-year return expectation of all major asset classes we model. It must also be noted that emerging markets has the highest projected standard deviation or volatility of returns as well. Some of the higher volatility we’ve experienced and come to expect arises from a variety of risks associated with these markets as detailed below.
Political
Dating back to late 2016, U.S. policy (or assumed policy in many cases) has been a meaningful driver of broad emerging market performance. After the U.S. election in November, emerging markets and their currencies slid significantly versus U.S. markets on the assumption that President Trump’s new Administration would favor a domestic agenda and in turn, negatively impact growth within emerging markets. The emerging markets rally in 2017 may be somewhat attributed to the Trump Administration’s inability to swiftly enact large portions of its domestic-oriented agenda, thus far. Beyond U.S. policy, overall political headlines often drive performance across emerging market nations. For example, a constitutional referendum in Turkey was narrowly approved in April, following a failed coup attempt in 2016. This referendum substantially consolidates Turkish President Erdogan’s power and merits continued observation. Similarly, in South Africa, some 20 members of the President’s cabinet were removed in late March, fueling uncertainty around domestic policy and capturing the focus of rating agencies. Political events, those mentioned here and countless others, have been a contributing factor to emerging market performance.
Economic
Given the historical reliance many emerging market nations have on commodity exporting, it’s of little surprise that crude oil’s difficult start (14%6 drawdown for the first six months of 2017) challenged many individual stock markets. While the traditionally tight relationship between commodities and emerging markets may be slowly weakening (lower correlations to start 2017 and a growing focus on the technology sector), markets such as Russia, and to a lesser extent Brazil, felt the pressure of falling oil prices. For the first half of 2017, Russia returned -15%7 while Brazil managed a return of +3%8, well behind their largest emerging peers (China +25%9, India +15%10) and the emerging market benchmark in total (+18%)11. Naturally, there are a number of other factors that also impacted performance for Russia and Brazil with political news continuing to serve as a significant headwind for both countries.
As noted above, China has enjoyed an extremely strong start to 2017, though concern over economic destabilization remains a constant threat. Much of the data has recently pointed to stronger than anticipated industrial production, news the market cheered given concerns over China’s closely-watched transition towards a more domestic-oriented economy.
The recent strength of emerging markets has followed periods of sharp underperformance, both short-term (Q4 2016) and longer term (2013-2015). This year’s outperformance is occurring within a challenging backdrop for oil, though a July rally has fueled hope for a second-half rebound in crude. The disparate nature of individual emerging markets continues to highlight the importance of selectivity – consider the first half performance of Russia versus China as just one example.
Though emerging markets continue to dig out of the 2013-2015 slump, there appears to be additional room for long-term growth, fueling optimism about this group of countries as a whole. Coupled with markedly lower CAPE ratios than developed peers, relative value appears to favor emerging markets. The potential for long-term excess return is created by the above-average volatility inherent in these markets. Uncertain political and economic policies ultimately drive long-term opportunity and 2017 thus far is no exception.
For further information and assistance with emerging markets in your portfolio or a copy of our 10-Year Capital Market Forecasts white paper, please contact any of the investment professionals at DiMeo Schneider & Associates, L.L.C.
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1,3,4,7,8,9,10,11MSCI
2FTSE Russell
5StarCapital Research
6Bloomberg
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| While this article addresses generally held investment philosophies of DiMeo Schneider & Associates, L.L.C., it does not represent a specific investment recommendation for any individual client or prospective client. Please consult with your advisor, attorney and accountant, as appropriate, regarding specific advice. Any forecast represents median expectations and actual returns, volatilities and correlations will differ from forecasts. Past performance does not indicate future performance.
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| This report is intended for the exclusive use of clients or prospective clients of DiMeo Schneider & Associates, L.L.C. Content is privileged and confidential. Any dissemination or distribution is strictly prohibited.
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