The Four Horsemen of EM Strength: Growth, Sentiment, Liquidity and Relative Value
While it is easier to slice market performance in a variety of ways, four dominant themes have had a significant correlation with EM relative performance historically: Leading economic indicators, investor sentiment, credit conditions, and relative valuation. This is not intended as an exhaustive list, but this relatively compact set of factors helps explain a significant portion of the variation in emerging market relative returns. And while there are obviously different ways to measure each of these conditions, we've attempted to assemble a list of simple, easy-to-track metrics to quantify each of these dimensions.
Growth. As emerging markets are perceived as benefiting from faster economic growth, it's not surprising that these markets perform best when that is actually the case. As with most equity markets, including developed ones, investors respond best to signs of future growth rather than trailing or coincident indicators. For this reason, leading indicators tend to work best as proxies for economic activity.
Table 1 illustrates the impact of China's leading economic indicators (LEI) on overall emerging market relative returns (we selected China as it is indicative of overall EM growth, both by virtue of its size and role in the global supply chain). When China's measure of leading indicators is above its long-term average, emerging markets typically outperform by an impressive 126 bps per month. In contrast, in months when China's LEI is indicating below-trend growth EM equities trail DM stocks by more than 1% on average. In addition, prospects for near-term growth seem to not only influence the average returns but also the likelihood that EM stocks will outperform. In months when leading indicators are above average, EM stocks outperform in nearly 64% of the months, versus less than 40% of the time when leading indicators are indicating sub-par growth.
In addition to growth in local emerging market economies, investors will want to also pay attention to overall, global economic conditions. In the past, global growth, as measured by the Global Purchasing Managers Index (PMI), has also coincided with significant differences in emerging market relative performance (see table 2). Historically, emerging markets have performed best in months when the global PMI is rising rather than falling.
This should not be surprising as large emerging markets are heavily weighted toward cyclical, global industries. In China, roughly 50% of the index is comprised of banking and financial companies, while another 25% is energy and natural resources. In Brazil, energy and resources are around 40%, with financials another 20%. And in Russia, energy and natural resource companies comprise more than 60% of the index. In each case, these equity markets are dominated by global companies whose fortunes tend to rise and fall with the global economy. Given this dynamic, it follows that global growth is as much, if not more of, a driver of returns.
Investor sentiment. Previously we've written how emerging market economies are becoming more stable, both in an absolute sense and particularly relative to those in developed markets. We would expect emerging market risk to converge with developed market risk over the long term, but today emerging markets are still more volatile than developed markets, and investors still behave accordingly. Last year was a good illustration of how investors still treat EM stocks as a convenient proxy for adding risk to a portfolio.
While emerging markets respond to the level of risk investors want to take, there is an important nuance to consider: The critical driver is the change, not the absolute level, of risk appetite.
As a proxy for investor sentiment, we looked at implied volatility, specifically the VIX Index, often referred to as the "fear index." When the VIX is high it indicates higher implied volatility for S&P 500 options, which typically coincides with periods of market stress, when investors are willing to pay a premium for put protection. Lower readings indicate less demand for put protection, suggesting greater willingness to take on risk. Over the past 20 years, the VIX Index has averaged around 19. During unusually calm periods - such as early 2007 when investors were arguably too complacent - the VIX Index has traded as low as 10. In contrast, at the peak of the financial crisis the VIX briefly touched 90.
Despite the intuitive relationship between investor sentiment and emerging market relative returns, there has historically been a statistically insignificant relationship between the level of the VIX and EM relative returns. For example, emerging markets underperformed developed markets for most of 1996, a period when implied volatility averaged around 17, comfortably below its long-term average. In contrast, emerging markets had a stellar run beginning in the midst of the financial crisis, from December 2008 through May 2009, when emerging markets outperformed developed markets by an average of more than 5% a month. During that period, the VIX Index averaged 40, more than twice its long-term average, suggesting that investors were sufficiently anxious as to be willing to pay an enormous premium for put protection.
But what distinguished the period of late 2008 and early 2009 holds an important lesson for the relationship between sentiment and EM relative returns. While the VIX was persistently high during that entire period, it was also consistently falling.
After reaching a peak of 90 in October 2008, the VIX Index fell to below 30 by the end of May 2009.
The above example illustrates the key point: It is the change in investor sentiment, not the level, that has historically driven emerging market returns (see Table 3).
Credit conditions. Somewhat related to sentiment are conditions in the credit market. In the past, improving credit market conditions have been a powerful catalyst for strong EM performance. Over the past 20 years, the correlation between credit conditions and emerging market relative returns was twice as high as any other factor we tested.
Why should this be the case? For starters, credit markets are often a driver of investor sentiment - as was certainly the case in 2008 and 2009. In addition, looser credit conditions are indicative of more monetary liquidity, which in turn facilitates leverage and a generally more aggressive pursuit of risk.
In order to measure credit conditions, we looked at the difference in yield between an index of U.S. high yield bonds and the 10-year Treasury note. When there is little systemic stress, spreads tighten as investors are willing to accept greater risk for higher yield. During periods of financial stress spreads widen as investors demand a greater premium to accept the credit risk inherent in high yield bonds.
As was the case with the VIX Index, the relationship between credit conditions and emerging market relative returns was driven by change rather than level (see table 4). In fact, the absolute level of credit spreads historically has had virtually no correlation with emerging markets relative returns, while the monthly change in credit spreads has had a -0.40 correlation (implying emerging markets do best when credit spreads are contracting). When emerging markets rallied from early 2009 through the fall of 2010, the spread between high yield bonds and Treasury notes fell by roughly 1000 bps, or by an average of roughly 55 bps a month.
Relative value. Finally, there is the influence of relative value on EM performance. One interesting historical anomaly is, despite all the histrionics in emerging markets, the ratio of emerging market to developed market valuations has remained relatively stable - at least measured by price-to-earnings (P/E) ratios - over time. Since 1995, EM stocks have traded at around a 20% to 25% average discount to developed markets (see chart 2).
This has been particularly true over the past seven years. Since 2004, valuations have been in a fairly tight range. The high of this range was in late 2007 when EM stocks were trading at a 7% premium, while in late 2010 EM stocks were at a scant 5% discount to developed markets. At their lows in 2008, EM stocks were trading at around a 30% discount. Today, EM relative valuations are right around the long-term average, at around a 20% discount.
Historically at least, it has been worthwhile to buy emerging markets when they are trading at a significant discount to developed markets and sell once they moved toward a premium. Looking at the last dozen years of data illustrates the difference (for the purpose of this exercise we've used annual rather than monthly returns as value tends to exert more of an influence over the longer term).
In those years when emerging markets started the year with below-average relative valuations, EM stocks significantly outperformed developed markets. In years in which EM valuations were high relative to developed markets, the record was more mixed, with EM typically trailing developed markets in those periods (see table 5).
Years when valuations were high included 2000 when EM underperformed by more than 17%, 2008 when EM came into the year at a premium and trailed DM by around 12%, and most recently 2011 when EM started the year at a relatively small discount.
Another way to view the impact of valuation on emerging market relative performance is through the lens of sentiment and risk appetite. When you consider 2008 and 2011, what these years had in common was that initial investor optimism morphed into acute risk aversion. In contrast, in those years when markets were more exuberant, EM investors did occasionally overlook excess valuations. For example, EM stocks outperformed in 2007, despite coming into the year at a historically small discount of 15%. In other words, for EM stocks it is better to start the year with relatively low expectations, which typically manifests as a large EM discount. This scenario provides more of a cushion for bad news than in years that begin with much good news already reflected in the price.
1. An option contract that gives the owner the right to buy a security at a set price within a specific time period, although there is no obligation to do so.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.