My prior articles on emerging markets (EM) investing and the Asia-Pacific are as follows: In Asia not BRATs, last August, I argued that the best EM prospects are selective Asian opportunities, excluding trouble-spots with serious current account (and therefore potential currency) issues. In Introducing MAPIX, in December, I looked at ETFs versus active funds as a way to gain exposure to the best EM-Asia prospects. In particular, I dug into a dividend-focused fund with an excellent track record that was overweight Asian consumer demand. Finally, in Trade - Fear vs. Greed, I took a closer look at the China Trade tariffs and the Chinese slowdown and argued that a) the Chinese slowdown had little to do with actual trade tariffs and was mostly about the central bank controlling credit growth, especially to the shadow banking system and b) actual China exposure to US trade was low enough that valuations more than made up for the risk. In this article, I revisit the "Why EM at All?" question and look at how things have been going since last fall.
Why EM At All?
One important issue I perhaps did not cover enough is the role of currency. One of the main reasons many US residents don't allocate as much as recommended to non-US markets (for example, Vanguard currently recommends 40% non-US exposure to young investors) is due to currency risk. They reason that since their retirement spending will almost all be in US dollars, it makes sense to keep all their funds in US Dollars. Another reason many US investors don't allocate as much as Vanguard recommends to overseas is that a lot of US equity funds' top holdings are already multi-nationals. They reason from this that they are already getting exposure to overseas sales from holding US companies that export. Finally, the last popular reason folks I have spoken to communicate for not investing in non-US companies is the last ten years of returns: the US has clearly done better than most foreign markets. So why mess with a good thing?
As the graph above shows, the S&P has beaten the EEM ETF substantially since the last bear market lows (16.7% a year to 8.5%). It has even beaten my current recommendation, MAPIX, which has returned 12.94% a year.
To address the currency issue, note that currency is both a risk and an opportunity. If the US dollar were to depreciate by 2% a year over the next 10 years (on average) relative to a basket of EM currencies, this could provide an easy tailwind to that EM basket. Has this ever happened?
The dollar index graph above shows that over 5-8 year periods, the dollar has indeed periodically declined by more than 20%. This has happened in the 70s, mid-late 1980s, as well as right after the internet bubble popped through 2008. Periods that see a declining dollar tend to have a few things in common: slowing US growth or higher inflation, a large current account/budget deficit (where we need to attract lots of foreign savings) as well as a dearth of very attractively viewed US investment opportunities. For example, from 1995 to 2000, the US had shrinking deficits (indeed we had our first budget surplus under Clinton), internet stocks were viewed as very attractive investments, and foreign capital surged into the US (even though we did not need as much of it due to our budget deficits shrinking). This pushed the dollar up quite a bit. When the process reversed, we got the 2000-2007 reversal. Interestingly, the dollar spike of the last few years coincides with the rising valuations of US equity markets, especially our tech sector.
So currency can definitely provide an opportunity and is not just a risk, especially given that budget deficits are rising and large trade deficits seem to be here again.
Indeed, for an example of what a currency tailwind combined with rising EM valuations can look like, we just have to take the graph from above comparing EEM and SPX back to an earlier period:
The 5 years from 2003-2008 where the dollar index was depreciating as internet bubble money returned outside our borders led to the EEM beating SPX by 24% a year. Quite a bit more than the recent cumulative out-performance of SPX in the most recent 10-years.
So the most obvious answer to the "Why EM at all?" question seems to be "because if your timing is right, you can make lots more money".
Is the Timing Right?
A host of metrics (ranging from Shiller-CAPE, Tobin's Q, market cap to total corporate sales) point out the relative richness of US markets to EM right now, but the simplest graph is perhaps the one below:
Source: US Equity Valuations
As this graph shows, prior to entering the 5-year period of massive under-performance relative to EEM that the SPX suffered (which we saw in the graph just before), US valuations were at another local peak. The recent run-up has increased differentials even more than last time. US corporations and the government are at new levels of indebtedness while the US consumer continues to slowly increase their savings rate and improve their balance sheet. The prospects for US growth continuing much above 2% real GDP growth remain low while segments of EM continue at 5-6.5% growth rates.
Since I began increasing allocation to EM last fall, this is what has happened in the short term.
EM in general bottomed earlier in the fall, beginning their recovery in October. The US markets appear to have bottomed in December, with the surprise dovish turn from the Fed helping the markets find a (we hope) bottom. The short-term graphs are therefore consistent with the longer term cycles we can gleam from the very long-term graphs above.
When thinking about the role of history in making decisions for the next 5-10 years, it is important to consider two opposing forces. Momentum effects tend to keep certain phenomenon going. Stocks, sectors, and markets that have been doing well keep doing well on a relative basis for a bit longer. Mean reversion effects, on the other hand, tend to seek equilibrium in fundamental relationships, such as the relationship between production or corporate profits and market caps. The two effects operate at different time scales. Momentum tends to dominate in most short- and intermediate-term time scales, except when it comes to turning points. Mean reversion tends to occur at intermediate- to long-term scales. Some times momentum lasts a little longer than you think it might (or mean reversion takes a bit longer to occur than you think it might).
Just like the smart poker player sizes her bets based on the cards that are showing and their knowledge of the odds, as well as a psychological understanding of her opponents, so should investing decisions be viewed as a function of odds, taking both momentum and mean reversion forces and fundamentals into account. Many signs currently point to this being an extremely opportune time to be begin an over-weight allocation to EM.
Disclosure: I am/we are long MAPIX. 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.