Emerging Markets and the Global Allocation Process.

Emerging market countries now represent over 40% of the global economy, and over 60% of its growth. This will only increase in the future. The IMF forecasts that emerging markets will grow a nearly three times the pace of developed markets over the 2017-2022 period, led by India and China. These two countries increasingly dominate EM investing. The two markets are relatively easy to invest in because of an abundance of large firms with liquid stocks, and they are becoming more and more attractive as companies tap into the world’s two fastest growing pools of middle class consumers.  Yet most investors in wealthy countries have very little invested in EM, and consider anything above a 10% allocation to be near-reckless. This is mainly because of “home-country bias” and investor preference for the familiar. However,  given the nose-bleed valuations in the U.S. and the relatively cheap stocks in EM, it is a risky allocation strategy to pursue. This was the point made recently by GMO strategist Jeremy Grantham when he encouraged his clients to put as much of their assets in EM as they can possibly stomach (GMO).

In addition to providing growth, emerging markets also provide significant diversification benefits. With only little over 40% correlation with the U.S., combining EM with an investment in the S&P500 reduces volatility by about 2.2%.

The diversification effect occurs because EM and the U.S. market tend to trend in opposite directions for extended periods of time. Because of links to the U.S. business cycle, Federal Reserve policy and the U.S. dollar, EM tends to perform well when the U.S. dollar weakens, providing a strong diversification benefit to dollar-based investors. The dollar typically weakens when global growth is strong and investors raise their appetite for “risky” EM assets. The weak dollar creates liquidity and credit in EM economies, resulting in strong upswings which are very rewarding for equity investors.

A simple strategy of rebalancing an EM index and the S&P500 provides surprisingly positive results. Rebalancing a 50/50 portfolio with the two assets increases returns while significantly reducing volatility over long holding periods. This is shown in the table below.

Moreover, significantly enhanced results can be achieved by adding some complexity to this strategy.

First, adding a timing tool, such as one-year relative momentum or a 200-day moving average, is effective. This allows the investor to stay fully invested during the long uptrends and avoid steep drawdowns. Such as strategy pursued over the past twenty years has produced annual returns of 13%, nearly double the returns provided by a 50/50 mix of and EM index and the S&P500 Index.

Second, the EM portfolio can be tilted towards the cheaper countries, also re-balanced on a periodic basis. Countries coming out of large down-cycles and trading with valuations well below their historic averages can be over-weighted as they initiate their recovery processes  (The Next ten years in EM ).   Boom-to-bust cycles are a feature of emerging markets, and the investor should have a well-defined methodology to exploit them for enhancing returns.

Lastly, an astute investor can create additional value (alpha) by  methodically tilting the portfolio to certain factors and picking superior stocks. My personal experience is that this can be achieved most effectively with a replicable,  formulaic approach. My preference is for a “Warren-Buffet-like” ranking of stocks in terms of both quality and profitability, building a screen which identifies stocks with the ability to compound high returns over time and that are valued at relatively low valuations.

 

Fed Watch:

  • China is the leading candidate for the next financial crisis (FUW)
  • The coming melt-up in stocks (GMO)

India Watch:

China Watch:

  • When will China become the biggest consumer economy (WIC)
  • Xi ally highlights financial risks (SCMP)
  • Davos; MNCs troubles in China (Holmes Report)
  • China’s rise is over (Stanford Press)
  • Dockless bike-sharing in China (Bikebiz)
  • Bridges to Nowhere, Michael Pettis (Carnegie)

China Technology Watch:

  • China and the U.S. wage the battle for AI on the cloud (Technology Review)
  • Hong Kong-mainland bullet-train links ready (Caixing)
  • China’s rental market takes off, led by techs (bloomberg)
  • The life of an express delivery man (FT)

EM Investor Watch:

 

Technology Watch:

  • Renewable power costs in 2017 (Irena)
  • Apple’s share of smartphone profits is falling (SCMP)

Investor Watch: