The developed market equities (including Japan) have outperformed the emerging market equity by a fair distance in the first quarter of 2013. The most significant outperformance comes from the U.S., Japan and U.K. equity markets. This article discusses the reasons for believing that the remainder of 2013 might not be rosy for the developed markets and they might underperform compared to emerging market equities. Even if returns remain negative for all markets, developed market equity might witness a sharper decline.
The chart below gives the performance of some key markets in the first quarter of 2013. Japan has been a clear winner with the BOJ committed towards an inflation target of 2% resulting in ultra expansionary monetary policies. The U.S. markets have also witnessed a strong upside amidst weakening earnings discussed in my earlier article. For the emerging markets, the returns have been negative.
The second chart, which incorporates all emerging and developed markets, also indicates the same trend. In the recent past, the divergence of returns from emerging and developed market equities has widened.
There is no doubt that growth in emerging markets has declined and central bankers are taking a more cautious than aggressive approach to rekindle growth amidst inflation concerns. At the same time, economic growth is not robust for developed markets. IMF data suggests that eurozone will be in a recession for 2013. Economic growth in the U.S. has been relatively robust. However, the latest jobs report does bring some caution. At the same time, nearly 40% of S&P 500 earnings come from the eurozone. If growth remains sluggish globally, U.S. corporate earnings will disappoint going forward.
Therefore, there are no big positive cues for developed markets, which can help equities sustain their rally. The liquidity driven rally can stall at any moment. It is important to remember that money flow has been swift from one asset class to another in the current easy money environment. The developed market equities might remain overbought in the near-term. However, a correction might just be round the corner.
On the other hand, emerging market equities look relatively depressed and valuations relatively attractive. As mentioned before, money has been swiftly moving from one asset class to another. It might therefore be possible that emerging market equities see relatively higher fund inflow over the next two quarters. This is especially true at a time when there are signs of economic recovery in China resulting from domestic demand. At the same time, growth in India has bottomed out in all probability. Further, with the Indian central bank cutting interest rates in the recent past, growth will be supported at current levels.
I am not suggesting the theory of financial market decoupling. The point I want to make is that it might be relatively better to be overweight emerging market equities than developed market equity at this point of time. Also, in the long term, emerging market equities will significantly outperform developed market equities. This is considering the impending infrastructural and developmental growth in emerging markets. Therefore, it does make sense to rebalance the portfolio at a time when investors can sell equities in developed market at rich valuations (certain sectors).
Considering the above discussed factors, it might be a good idea to consider exposure to the following ETF's -
Vanguard MSCI Emerging Markets ETF (VWO) for exposure to emerging market equities. The fund invests in stocks of companies located in emerging markets around the world, such as Brazil, Russia, China, Korea, and Taiwan. The fund has a low expense ratio of 0.2%.
iShares FTSE/Xinhua China 25 Index (FXI) for specific exposure to Chinese equities. China looks attractive at current levels and growth in China has bottomed out in all probability. I would still take a cautious stance and gradually invest in China.
iShares S&P India Nifty 50 Index Fund (INDY) for specific exposure to Indian equities. Growth in India also seems to have bottomed out and the recent interest rate cuts might trigger growth.
iShares MSCI Brazil Index ETF (EWZ) for specific exposure to Brazilian equities. I consider Brazil as an excellent natural resource play and I remain bullish on agricultural and industrial commodities for the long term. Recovery in China and India can be positive for equities in Brazil.
iShares MSCI Russia Capped Index Fund (ERUS) for specific exposure to Russian equities. Natural resources (energy) will be the primary growth driver for Russia in the long term. The market does look attractive with a long-term perspective and can give the double benefit of currency and stock market appreciation.