After a brutal decade for emerging markets stocks marked by poor absolute returns and dismal performance relative to the S&P 500, it is timely to review how the asset class fits into a global allocation process.
Any investor in emerging market bonds or stocks, unless he or she is a dedicated portfolio manager with a mandate to outperform an EM index on a short term basis (1-3years), should operate under the following assumptions.
1.“Buy-and-hold” does not work in EM.
2. Risk always trumps valuation in EM stocks and bonds.
3. EM stocks are liquidity-driven trending assets.
4. The U.S. dollar drives returns and is negatively correlated to EM stocks and bonds.
The first premise – “Buy-and-hold” does not work in EM – is derived from the other premises. Emerging markets are too subject to “sudden stops” of liquidity to provide reliable returns for investors over meaningful periods, say over a decade. Empirical evidence clearly guides investors to avoid “sudden stops” by focusing more on risk than on valuation. Risky market conditions, measured by macro vulnerability (debt, deficits, overvalued currencies), domestic politics and geopolitics (e.g., Russia), will almost always trump low valuations. Low valuations and low risk provide the best conditions, but you are better off owning expensive stocks in a low-risk country than cheap stocks in a risky country. Of course investors tend to do the opposite, as we last saw in 2008-2012 when EM bulls courted disaster by buying extreme valuations at a time of extreme risk.
If buy-and-hold is a losing strategy, the question is how to time allocation exposure to EM markets. The answer lies in premise three and four. History shows us that EM assets are trending assets, and this is for good reasons. Therefore the job of the allocator is to identify the trends and ride them until they exhaust themselves. The first chart below shows the performance of the MSCI EM stock index relative to the S&P 500 over its 35-year history. We can clearly see two periods when allocations to EM stocks paid off handsomely for investors: 1987-1994 and 2001-2012. Unfortunately, all this relative outperformance was wiped out in the past ten years. The second chart, from BOFA’s recent 2023 Market Outlook, shows the relative performance over a much longer 72-year period. Though it is problematic to come up with a realistic EM index over this period, BOFA’s data shows a third massive cycle of outperformance for EM stocks lasting from 1970-1980.
There are two fundamental causes behind these long trends: valuations and the U.S. dollar. Three of the peaks in U.S. performance (1970, 2000, 2022) are characterized by very high valuations in the U.S. (the Nifty Fifty bubble in 1970, the TMT bubble in 2000 and the Everything Bubble of 2022) and an overvalued dollar. All the periods of EM outperformance start with low relative valuations and an expensive dollar. This insight is confirmed by the DXY dollar index, shown in the next chart. Every spike in the DXY (dollar strength) is accompanied by strong relative performance of U.S. assets.
This relationship between the USD and EM stocks is further illustrated in the chart below. We can see the obvious negative correlation between EM stock prices and the DXY.
Another chart from the BOFA 2023 Outlook points to another fundamental correlation with important consequences for EM investing. This chart shows how growth stocks (tech and healthcare ) are negatively correlated to value/cyclical stocks (energy and financials).
This is a critical insight with important implication for EM allocation. EM stocks can be considered value stocks with a dominance of cyclical exposure in commodities and industrials.
We can see this insight confirmed by the chart below which shows the correlation between the S&P Industrial Metals Index (GSCI) and the DXY. The chart looks almost the same as the chart above that showed the relationship between EM stocks and the DXY.
As we can deduce from the following chart, EM stocks are a leveraged play on the prices of industrial metals.
This relationship leads to a further important insight for EM allocation. On both a global or a country basis, the simplest and most cost-effective manner to gain exposure to EM stocks is through commodity stocks. This is shown in the next two charts, which show first the performance of mining companies relative to the EM index and the performance of Vale relative to the Brazilian index. These stocks outperform massively on the uptrend and underperform on the downtrend.
Therefore, for a global allocator investing in emerging markets can be simplified to owning blue-chip mining firms during upcycles and unloading them when the cycle turns. However, we still have to identify the cycles. To do this the allocator must follow the trends and valuations.
A simple method to gauge the condition of the long-term trend is to look at the one-year relative performance of the S&P 500 relative to EM stocks and the U.S. dollar relative to other currencies.
The chart below shows that the S&P 500 continued to outperform EM stocks (with and without China) over the past year.
The DXY also is still in an upward trend on a 1-year, 3-year and 5-year basis, as shown below.
Valuation is also an important element in determining turning points. We know that U.S. stocks and the U.S. dollar both are very expensive relative to history. As shown below, we also can be confident that EM stocks are cheap relative to their own histories and compared to U.S. stocks.
A sign that a new trend may be forming is that value, cyclicals and the cheapest EM stocks (e.g., Turkey) all have been outperforming this year, while U.S. tech is faltering.
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