Riding The U.S. Equity Market Wave With Emerging Markets

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Summary

Major international equity markets have extended in early 2017 the 2016 positive trend, with the US equity markets leading the pack;

In our view, the outlook of the US equity markets remains positive in the short term. The main reason for optimism is the solid perspective of the US economy;

Despite the indications in favor of the continuation of an upward trend of the US stock market, we think that the 2017 performance will be lower than in 2016;

In this scenario, we think that emerging markets could represent an interesting opportunity for investors as the economic outlook has definitely improved;

According to the investment manager GMO, emerging market stocks could return an average 4.4% per year over the next 7 years; higher than other US and international stocks.

Major international equity markets have extended in early 2017 the 2016 positive trend. For example, the US equity markets rose during the last week to the historical high, with the Dow Jones Industrial above 20k threshold for the first time ever.

In our view, the outlook of the US equity markets remains positive in the short term. The main reason for optimism is the solid perspective of the US economy, as signaled by data recently released. The ISM manufacturing index for January due on Wednesday, 1st February should confirm the positive picture, edging up from 54.7 to 55 (Bloomberg survey consensus estimate). It would be a value in line with an annual GDP growth of 3.6%. The solid perspectives of the economy should reinforce analysts' expectations for a strong growth of corporate profits in 2017. According to the latest consensus estimates gathered by Factset, S&P 500 corporate profits should grow by 11.4% in 2017, albeit a downward revision of these estimates during the year is likely. It would be a marked acceleration compared to the 0.2% recorded in 2016.

Encouraging signs also come from market indicators. For example, both the NYSE ADline and the major trend indicators (i.e. 200 day moving average, 12 months momentum) are in an upward trend.

Despite the indications in favor of the continuation of an upward trend of the US stock market, we think that the possibilities that 2017 performance will replicate the 2016 one (9.5%) are thin. The forward 12-month P/E ratio for the S&P 500 is 17x, well above the average of the last 5 and 10 years. In this scenario a further expansion of P/E seems unlikely. According to a widely used long-term valuation model based on 10 years P/E ratio and the long-term average profit growth rate, the expected S&P 500 performance over the next 10 years is below long-term average.

The increase of 10 year government bond yields over the last few months - from 1.4% in July 2016 to 2% in the aftermath of the election of Donald Trump as new US president to 2.5% over the last week - could weigh on the S&P 500 performance in the months to come. Indeed, in the past the S&P 500 recorded monthly average returns of 1% in the months when the 10 year government bond yield was below previous year level and 0.4% when it was higher.

In this scenario, we think that emerging markets could represent an interesting opportunity for investors. Indeed, the economic outlook of the main emerging countries has definitely improved over the last few months. For example, according to the latest IMF's World Economic Outlook, Brazil and Russia should grow in 2017 by 0.5% and 1.1% respectively after the 3.3% and 0.8% contraction in 2016.

The strong rebound of currencies over the last few months is the strongest sign of the improved economic scenario. From the historical low against the US Dollar the Brazilian real has gained 22% and the Russian ruble 24%. Emerging countries should also benefit from the rebound in commodity prices, as many emerging countries are commodity exporter. The rise in commodity prices is also a positive sign for the world economy, strengthening growth expectations on the growth of these countries in the current year.

For these reasons, investors could put aside in the short term the concern on the consequences of the tightening of monetary policy from the Fed, which could reduce liquidity in the markets and lower world economy growth rate. The recent decline of the US Dollar - the Dollar index has lost 2.4% year to date - could also encourage investments in the emerging markets.

Finally, emerging market stocks look the most promising in a long-term perspective. According to the investment manager GMO, emerging markets stocks could return an average 4.4% per year over the next 7 years, well above the expected -3.1% of large US stocks, the -2.1% of small caps and the 0% of international stocks.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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