Imminent Peak in Industrial Production May Affect Emerging Markets (EEM)

The euphoria of U.S. investors towards international stock markets continues, as all-time record investment flows are being directed into foreign-focused mutual funds and ETFs. In the first quarter, an unprecedented level of $62 billion has flowed into foreign-focused mutual funds and ETFs, outpacing the $19 billion of new cash flows into U.S. focus funds by a margin of more than 3-to-1.

Apart from the current enthusiasm for foreign equities, overseas stock valuations relative to U.S. have risen significantly as a result of their outperformance as compared to U.S. stocks. For example, the P/E multiple of the MSCI EAFE index is now on par with the U.S. at 18 trailing earnings, after having traded at a 20% discount two years ago. In addition, the price-to- book multiple of the MSCI Emerging Markets Index is trading in the 98th percentile of valuations since 1990. Taken together, these factors suggest it is time to be cautious and temper expectations for foreign stocks.

Another developing risk is the potential for a downturn in industrial production in the second half of this year. The Economic Cycle Research Institute, our favorite business cycle forecasting firm, recently reported that its leading indicators for global industrial production have “turned down quite clearly” implying “a peak in global industrial production in the second half of this year.” Acccording to ECRI, the global industrial sector may surprise on the downside later this year, relative to current frothy expectations. If ECRI’s forecast is accurate, we would expect emerging markets, which are most leveraged to global industrial production, to be particularly affected. In light of the above factors, risk averse investors wanting to protect gains in the MSCI Emerging Markets position (symbol: EEM) could consider trimming their position here or using a stop-loss order at the $98/share level, which is just below the 50-day moving average.

EEM 1yr chart: