Month: July 2019

Update on the Expected Returns for Emerging Markets Stocks

Emerging markets have returned a decent 10.6% in dollar terms through June. However, over the past year EM has returned only 1.6% and over the past five and ten years EM annual returns have been a meager 2.9% and 6.2%, respectively. These returns have strongly disappointed investors, particularly in contrast to the stellar returns of U.S. stocks. As can be expected, the poor results have spawned dozens of articles on the futility of investing in emerging market equities, the latest this week from the Financial times (Does Investing in Emerging Markets Still Make Sense?).

Notwithstanding the poor recent results, if we look at the past twenty years the picture is very different, with EM significantly besting the S&P 500. In fact, the past two decades have been pretty much opposites. The previous decade (1999-2009) for emerging markets had started with low valuations and was characterized by favorable macro-conditions: rising commodity prices and a weak dollar. On the other hand, this past decade for EM started with very high valuations and was marked by falling commodity prices and a strong dollar. The chart below shows the relative performance of EM stocks relative to the U.S. market for the past two decades (SPY for the S&P500 and the Vanguard EM Fund-VEIEX)

So, where do we stand today as we approach 2020?. Investors, as usual, suffer from recency bias and now cannot fathom that current conditions may change and that the U.S. market could falter.  This, despite very high valuations in the U.S. on earnings which are inflated by low interest rates, loose fiscal policy, elevated margins and record levels of stock buybacks. In his latest article, Ray Dalio predicts that these conditions are unlikely to persist in the next decade, as authorities turn to debt monetization to address the rising tide of government debt and other liabilities (Link). If this were to happen, conditions much more favorable for EM stocks — a weak dollar and rising commodity prices — would follow. Given the low valuations and depressed earnings in EM, we could see much better returns ahead.

Based on current valuations and assuming a process of mean reversion supported by improved market conditions, we can try to estimate expected returns. The chart below does this be assuming that over the next seven years current valuations (based on CAPE-Cyclically Adjusted Price Earnings) will revert to the historical median, while the business cycle in each country will return to a neutral point at which earnings grow in tandem with nominal GDP growth. These highly simplistic assumptions is the best we can do to estimate future returns. Given that in EM we are now below normal in both multiples and earnings and observing that markets invariably overshoot on both the downside and  upside, these estimate may prove pessimistic if market conditions actually improve. An investor should optimize returns by tilting a portfolio to the countries that are currently valued well below historical norms and are also in depressed economic conditions; Turkey, Chile, Malaysia, Korea and Colombia currently promise the higher returns. Finally, it must be noted that these estimates assume no changes in current views on potential GDP growth. Therefore, for example, if a country like Brazil were to successfully implement deep structural reforms which boost potential GDP the estimates for that country would be too conservative.

CAPE Ratios Relative to History, June 30 2019
Current Cape Historical AVG CAPE Difference Earnings Cycle 7-Year Index Annual Return 7-Year Total Annual Return
Turkey 4.8 9.45 -49.21% Early 13.8% 16.7%
Chile 14 20.875 -32.93% Early 9.9% 12.9%
Malaysia 12.1 18 -32.78% Early 8.4% 11.7%
Korea 10 14.05 -28.83% Early 8.5% 10.2%
Colombia 11.2 15.55 -27.97% Early 8.8% 11.7%
Mexico 14.6 19.075 -23.46% Early 9.0% 11.0%
S. Africa 12.9 16.025 -19.50% Early 5.7% 8.8%
China 12.2 14.825 -17.71% Mid 8.5% 11.3%
Philippines 19.7 23.5 -16.17% Mid 9.0% 11.7%
Indonesia 15 17.725 -15.37% Mid 6.7% 9.5%
GEM 12 13.975 -14.13% Early 6.3% 9.2%
Russia 5.99 6.875 -12.87% Early-mid 4.9% 9.5%
Taiwan 16.3 17.85 -8.68% Late 5.0% 8.0%
China A-shares 16.3 17.025 -4.26% Mid 6.5% 9.1%
Brazil 12.3 12.225 0.61% Early-Mid 2.8% 6.4%
Peru 17.9 17.3 3.47% Mid 6.0% 8.6%
Argentina 10 9.525 4.99% Early 4.0% 6.6%
India 20.5 19.4 5.67% Mid 8.5% 10.0%
USA 30.2 26.3 14.83% Late 1.0% 3.3%
Thailand 17.8 13.25 34.34% Late 0.0% 3.5%

These estimates are broadly in line with those currently posted by GMO ( Link) and Research ( Link), two firms with  their own methodologies for predicting expected market returns.  The GMO numbers are for seven years in real terms, while the RA numbers are for 10 years in nominal terms.

Even with the good prospects for better relative performance over the next decade, current macro conditions still justify cautious positioning in EM stocks. The global economic slowdown, the U.S.-China trade and technology conflicts and a turbulent presidential election in the U.S. does not provide a backdrop propitious to increase “risky” investments in EM.  In any case, the macro indicators we look at remain neutral to unconstructive. Our macro drivers of EM stocks are 1.global liquidity, 2.risk aversion, 3. The dollar/EM currency trend and 4. Commodity prices.

Global Liquidity– Neutral.

The world economy runs on dollars and stalls when dollar liquidity tightens. Since the Fed pivot in January, year-on-year increase in dollar liquidity (U.S. money supply plus Central Bank reserves at the U.S. Fed) has recovered somewhat from very low levels. However, dollar reserves are contracting, a sign of declining global trade. Yardeni’s Global Capital Flows indicator also points ti tight dollar liquidity.

 

Risk Aversion – Neutral, with slight deterioration trend.

The best indicator for risk appetite is the spread between U.S. 10-year bonds and High-yield bonds. This indicator is highly correlated to EM sovereign spreads and appetite for EM risk in general. The spread appears to have started a rising trend, but remains very low. These low spreads indicate strong demand for yield in a world dominated by low and negative interest rates, and this is currently the major source of support for EM assets.

The Dollar Trend – Neutral to negative

The dollar is in a consolidation zone relative to emerging markets, but still appears in a long-term strengthening trend.

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Commodities-Negative

The CRB Raw Materials index measures prices for a broad variety of industrial inputs. Historically, this index has the highest correlation with EM equities. Following a strong rebound in 2016-2018, the index has resumed the downtrend started in 2012. The metals component of the CRB is also in a sharp decline.

In conclusion, after the recent rally in EM assets, some caution is warranted. For investor optimism to be rewarded, it is important that the four pillars of EM asset prices (global liquidity, risk appetite, the dollar and commodities) turn favorably.

Trade Wars

 

  • Balkanizing technology will backfire on the U.S. (FT)
  • Is American diplomacy with China dead? (AFSA)
  • The Russia-China close partnership (Carnegie)
  • Gavekal on the U.S. China new cold war (gavekal)
  • China, the art of wait and see (project syndicate)
  • The imperative of a Euro-pacific partnership (Project Syndicate)
  • Investing  for a new cold war (Gavekal)
  • The trade war needs a global solution (Carnegie)

India Watch

  • India’s digital transformation (McKinsey)

China Watch:

 

  • China and the World (Mckinsey)
  • Chinese internet weekly (seeking alpha)
  • China internet report (SCMP)
  • China’s elite obsession with Harvard (The Economist)
  • China’s Silicon valley (The Economist)
  • China’s sport-shoe capital  (SCMP)
  • Carrefour leaves China (WSJ)
  • The rise of factors in the China A share market (MSCI)
  • How does factor investing work in China (Indexology)
  • How smart-beta strategies work in China (Savvy Investor)
  • China’s healthcare sector (globalx)
  • China’s Communication Services Sector (globalx)
  • China’s rare earths strategy (China File)
  • China-India relations are stressed (Carnegie)
  • China opens yuan commodity futures (SCMP)

China Technology

  • Inside China’s biopharma market (McKinsey)
  • China’s food delivery war (Bloomberg)
  • How China took the lead in 5G technology (WP)
  • China’s MIC 2025 plans are roaring ahead (SCMP)
  • China’s EV future (The Econoist)
  • China’s EV bubble (Bloomberg)

Brazil Watch

 

EM Investor Watch

 

Tech Watch

  • Investing in Asian Innovation (Oppenheimer)
  • Trends in battery prices (BNEF)
  • Mary Meeker’s Internet Trends report (techcrunch)
  • Germany is losing the battery war (Spiegel)
  • Does automation in Michigan kill jobs in Mexico? (World Bank)

Investing