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What to think about Recent Emerging Markets-Led Volatility

Wow! This has certainly been an exciting few days for global financial markets, led by sharp weakness in various Emerging Markets (stocks, bonds, currencies). Figure 1 below highlights how the Russian Ruble and Turkish Lira currencies have both suffered extensive weakness against the US dollar over the last month or so, this weakness accelerating over the last few days.

1. Russian Ruble, Turkish Lira Weaken sharply vs. US Dollar

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UK-based investors in Emerging Market stocks have been hit over January by the double whammy of falling stock prices and weakening currencies, as foreign investors flee Emerging Markets exposure for "safer" developed markets. As examples, the Templeton Emerging Markets (TEM) and JPMorgan Russian (NYSEMKT:JRS) investment trusts have suffered drops in excess of 10% since the beginning of November 2013 (Figure 2):

2. Emerging Markets Investment Trusts Take a Battering

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EM Tough Also as Export Markets

Now, Emerging Markets have not only been tough for foreign investors, but also in business terms for a number of UK-listed companies too: today, the drinks giant Diageo (DGE) announced results, and included the comment that a number of emerging markets had been difficult for them (including Nigeria and Eastern Europe), particularly in their beer division. Rather predictably, their share price has taken a tumble today, down around 5% on this disappointment (Figure 3).

3. Diageo Also Catches an Emerging Markets Cold

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So, should we as investors call time on the bull market in stocks that has been such an enjoyable rise up since November 2012? Or are we at risk of "throwing the baby out with the bathwater", overreacting to a number of problems in Emerging Markets that will not necessarily spell the end of the bull run in Developed Market stocks?

Putting This in a Longer-Term Context

Let's take a deep breath in, and consider where we find ourselves today in this bull market trend.

Exhibit A: The Value Line Arithmetic index (VALUA). This index represents the stock price evolution of the average US stock, without reference to size of company. So in this index, a mega-cap like ExxonMobil has exactly the same weight as a US small-cap with a market cap a fraction of Exxon's. And what do we conclude from Figure 4? That the bull market for the average US stock is still intact, in spite of the recent mini-pullback on the back of further Federal Reserve tapering of bond purchases (from $85bn monthly to $75bn monthly in December, and now from $75bn to $65bn monthly).

4. No Breakdown in the Average US Stock's Bull Run

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Exhibit B: The FTSE UK Small-Cap index (ex investment trusts: SMXX).UK small-cap stocks continue to outstrip their mega-cap UK brethren by some margin, and also maintain the bullish uptrend that has been in place since late 2012 (Figure 5):

5. UK Small-Caps Still Close to Multi-year Highs

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Exhibit C: The US VIX Volatility index (VIX). The so-called "Fear Index" has spiked higher in recent days as a result of this emerging markets turmoil, but has still not reached the peaks touched in 2013, never mind the scale of the volatility spikes in 2012 or 2011 during the Eurozone peripheral countries crisis (Figure 6).

6. The VIX Volatility Index Is NOT at Worrying Levels, At Least Not Yet...

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Even excluding the 2008 global financial crisis, the VIX index has averaged a reading of over 19 between 2000 and today. So the current reading of 17.4, while elevated with regards to the mid-January level of 12.5, is still well below the long-term (ex-crisis) average for this stock market volatility measure.

I could go on citing other indicators that do not exhibit any real signs that the uptrend in risk assets is over yet, but I think you all now get the general picture. So far, the clouds on the financial markets horizon do not look pregnant with heavy rain, but rather our investment enthusiasm is being dampened by what seems more like a light drizzle.

How Will We Know If Matters Turn More Serious?

Of course, the situation can always change for the worse, and we should always remain alert to such a possibility. I would never deny that there are a number of structural concerns that affect various large emerging economies such as Brazil, Russia and Turkey. However one interesting snapshot that we should watch for clues as to whether this current market pull-back develops into something potentially more concerning is the relative performance of various European stock sectors.

Normally, during a stock market correction phase, as the market falls so-called "defensive" sectors (with more predictable and less economically-sensitive sales and profits) should outperform more cyclical sectors (with less predictable and more economically-sensitive business models).

However, thus far this generic financial markets script is not being followed! Figure 7 illustrates that the three worst performers of the 19 industry groups in the STOXX Europe index are all defensive (Personal Goods, Retail and Food & Beverage), the complete reverse of what one should normally expect... And the industry leaders over this 3-month period have actually been cyclical sectors like Travel & Leisure (e.g. airlines), Autos and Construction.

7. "Defensive" Sectors Have Generally Fared Worst As Emerging Markets Dropped

 

Perhaps we should not be so surprised at this contrary industry result, given that economic data point to the European economy picking up rather nicely right now, led by none other than good old GB and Northern Ireland!

So what am I looking at right now?

Without going over the top, I am cautiously adding to my positions in Small-Cap stocks where the price trends remain stubbornly positive in the face of weakening Large-Cap indices.

For a US-based investor, the easiest way to play UK Small-Caps is via the iShares MSCI UK Small-Cap ETF (BATS:EWUS).

If you would rather a European small-cap fund, Wisdomtree offer an interesting twist via their Wisdomtree Europe SmallCap Dividend fund (NYSEARCA:DFE), which currently offers a 2.4% dividend yield in addition to exposure to my current preferred investment style.

In the US, I would favour rather a Mid-Cap value ETF like the iShares S&P 400 Mid-Cap Value ETF (NYSEARCA:IJJ), given that over the longer-term in the US, mid-caps have tended to outperform small-cap indices.

Source: Global Markets: At A Turning Point?