This week, my call focuses on the relative opportunities in developed markets versus emerging markets.
I started the year with a bias for developed market equities over emerging market equities. Year-to-date, developed equity markets have outperformed emerging markets by roughly 4%.
I had two main reasons for favoring developed market equities. Emerging market equities looked expensive relative to their developed market counterparts and I felt that emerging market inflation would be a more persistent problem than the market was discounting. Now, however, these major rationales for broadly favoring developed markets no longer hold.
From a valuation perspective, last fall, while emerging market stocks looked reasonable on an absolute basis, they were expensive relative to developed market equities. At their peak, emerging market stocks were trading close to par with developed market stocks. While I do think that the valuation gap between emerging and developed markets is likely to narrow over time, emerging markets trading at the same valuation as developed market stocks seemed too much too soon.
Today, the spread has once again widened, with developed markets trading at an 18% premium to emerging markets, close to their five-year average. In other words, emerging market stocks are now once again trading at a significant discount to their developed market counterparts.
I now also believe we are nearing the end of the emerging market inflation cycle. Most of the emerging market countries have been aggressively raising rates and tightening monetary policy throughout the year. As such, while I have yet to see any real deceleration in inflation, inflation has stabilized in most of the large emerging market countries, most notably in Brazil and Russia. In fact, I am now as worried about a hard landing as I am about inflation in emerging market countries.
Two other factors that were not part of my original analysis also suggest a neutral stance towards emerging markets. Economic growth is an important component in my country selection model and growth prospects are increasingly favoring emerging market countries. Leading indicators in emerging markets, for instance, have for the most part performed much better than those developed markets.
In addition, given the intensification of the sovereign debt issues in Europe, the US and Japan, there has been a meaningful increase in credit default swap spreads in many of these countries. All else equal, this suggests a more balanced view between emerging and developed market countries and that developed market countries merit a lower valuation. In fact, given the budget problems of many large developed countries, it is no longer the case that developed market countries are viewed as a “safe haven” investment.
For all of these reasons, I am now ending my broad preference for developed markets over emerging markets. While there are a number of developed markets I continue to favor, most notably Germany, I no longer maintain a blanket bias in favor of developed markets. Instead, I now hold a neutral view of developed and emerging markets relative to each other.
And while I am not changing any specific country views this week, I do expect to initiate overweight views on a number of emerging market countries – many in Latin American – in the coming weeks. Finally, while I continue to hold an overweight view of global equities overall from an asset allocation standpoint, I would encourage investors to consider their international allocation on a country or regional basis rather than by using an emerging market vs. developed market framework (possible iShares solutions: OEF, IOO, EEM).
Disclosure: Author is long IOO
Disclaimer: In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume. Securities focusing on a single country and narrowly focused investments may be subject to higher volatility. Asset allocation may not protect against market risk.