The relative performance of emerging market stocks (EM) to European indices (Eurostoxx 50) tracks the overall trend of EM currencies against EUR fairly well (I do an approximation by comparing the dollar denominated 3-month returns of CEW to the EUR/USD variation). This suggests that any outperformance of one index against the other is enhanced by the underlying trend of currencies.
A quick look at the chart above would suggest that there is no relative valuation issue, but other cross asset signals might be more puzzling.
1. Value/Growth: If we oversimplify, we may expect to associate EM with Growth and Europe with Value. I gauge this assumption by crossing our EM/Europe return differential with the ratio of global MSCI value-to-growth return spread. The measure has flaws but we see that there used to be a clear cut relationship until late 2013. Interestingly enough, this is no longer the case.
2. Long-term yields: Given that value outperforms growth in a rising rate environment, it is no surprise that EM would underperform Europe when U.S. Treasury yields are on the rise.
Interestingly enough, the relationship holds better in the end-period: the traditional drivers of value and growth do not "work." Contrary to conventional wisdom, higher U.S. Treasury yields would clearly be beneficial for EM stocks on a relative value basis.
3. Commodities: Given the higher exposure of the asset side of EM countries to growth-related commodities (copper, oil), it might seem a little odd that the relative performance of EM to Euro stock indexes is related to the gold-to-oil ratio and not the other way around. This is probably linked to the fact that gold is strongly and negatively linked to the USD (hence the irrelevance of using relative commodity prices here).
4. Global Growth: The outperformance of EM to European stocks tracks the marginal changes of growth dynamics decently well (i.e. the 3-month change of economics news flow). The recent trend of this growth differential is already high and would call for EM stronger outperformance but also a mean reversion (hence a lower incentive to go long EM). The ongoing signs of economic acceleration in EM (e.g. Copper Prices and China PMI, for instance) would make me lean on the more optimistic side.
Bottom Line: There are signs that the DXY could strengthen in the medium run (U.S. news flow, some safe haven flows, monetary policy), which could clearly send a signal towards EM currencies. Interestingly, past history shows that the EM currencies tend to appreciate against the EUR when the DXY rises. A stronger USD would therefore add support to an outperformance of EM stocks, which would be even more likely if the global news flow continues to improve.
To sum up, Stronger USD + Higher U.S. Treasury yields + Tentative recovery in Global Growth = outperformance of EM stocks against their European counterparts
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