Top-down Allocation and Country Selection in Emerging Markets

The first quarter of 2018 has been a wild ride for emerging markets investors.  An early January surge was followed by a 10% correction in February, as EM stocks reacted to the return of volatility in the U.S. markets. In recent weeks, concerns with global trade wars and slowing growth in China and Europe have dampened enthusiasm. Signs of rising risk aversion can be seen in the strengthening dollar and falling commodity prices. Any confirmation of this trend would be worrisome for emerging markets investors.

Nevertheless, the odds still appear to favor an extension of the rally in emerging markets which has resulted in over two and half years of strong outperformance for EM.

First, the assumption continues to be that Trump’s trade-war talk is largely posturing and that common sense will prevail. Recent evidence that NAFTA talks are making good progress points in that direction.

Second, as confirmed by Fed Chairman Powell this week, U.S. growth prospects are strong while inflation continues to be tame. In fact, as the IMF stated in its most recent forecast, the global growth outlook continues to be healthy, and inflationary pressures mild. The combination of (1) a vigorous late-cycle U.S. economy fueled by fiscal deficits and declining private savings and (2) solid global growth is very supportive of a weakening dollar, rising commodity prices and buoyant asset prices in emerging markets.

Third, in a world of high asset prices, emerging markets are reasonably priced both relative to their own history and relative to other markets such as U.S. equities. The chart below compares EM valuations to the S&P500. While cyclically-adjusted price-earnings ratios (10-year average of inflation-adjusted earnings) for the S&P500 are 30% above both the historical average and the average for the past 15 years, EM is in line with the historical average and 8% below the average of the past 15 years. The 12-month forward looking PE for EM is an undemanding 12.2, vs a relatively high 17.5 for the U.S. Bear in mind that many EM countries are in early stages of their business cycles and can expect cyclical improvements in margins and profits, while the U.S. is in the later stages of its business cycle and can expect the opposite.

Given the diversity of countries in the emerging markets equities asset class, the investor taking a top-down point of view can improve returns by concentrating investments in the markets displaying cheap valuations, improving economic conditions and liquidity-driven momentum. This can be achieved at low cost and effort through ETF country-index products. More ambitious investors can further enhance returns by tilting the portfolio to additional factors (e.g., value, quality, etc…) and also by picking stocks with extraordinary upside potential.

The results of a top-down analytical process is shown in the chart below. Though considered a Frontier Market, Argentina is included because it is widely believed that it will be soon included in the EM indices. Countries are ranked based on three criteria:

  • Valuation – Current CAPE valuation relative to history and to the past 15-years, plus a mean-reversion factor.
  • Macro – A measure of where the country lies in its business cycle.
  • Liquidity – A measure of liquidity factors driving upside momentum in asset prices.

 

The results show that today in emerging markets the vast majority of countries show good characteristics. At the top of the list (3-ranking) are countries that trade at low valuations and appear to have both the business cycle and liquidity flows in their favor. These are mainly commodity producers like Chile and Brazil that were hit by the sharp downturn in commodity prices in 2014-2015.

Indonesia, Colombia and Mexico all sport attractive valuations and macro-characteristics, but are burdened by week flows. These can change quickly, so investors should keep a close eye on these markets.

Both Taiwan and Korea have benefitted handsomely from the strong tech cycle and may be set to take a breather.

At the bottom of the rankings, the Philippines, with high valuations and late in the business cycle, and Argentina, with valuations ahead of fundamentals, are vulnerable.

Investors should concentrate their emerging market holdings in those countries with rankings of two and three and stay clear of those with negative rankings.

 

Fed Watch:

India Watch:

China Watch:

  • What the West doesn’t get about Xi  (NYtimes)
  • Interview with CEO of Mengniu, China’s leading dairy firm (McKinsey)
  • The complex ties between China and Australia (WIC)
  • The turning point for land-reform (Caixing)
  • Chinese firms dominate video-streaming in China (SCMP)
  • Hillhouse capital raises record PE fund for China (FT)

China Technology Watch:

  • China wants to set the standards for AI (Technology Review)
  • Watch China to see the future of digital innovation (AllianceBernstein)
  • Naspers to sell $10.6 billion of Tencent stock (SCMP)
  • China drives AI into healthcare diagnostics (Tech Review)
  • Geely’s Global Rise (WSJ)
  • Kuka’s rise in China with Medea (SCMP)

EM Investor Watch

  • Thailand’s economic transformation (Opengovasia)
  • Wisdom Tree’s SOE-free EM fund shines (Wisdom Tree)
  • The future of manufacturing in Africa (SET)
  • Insider trading in the Mexican market (bloomberg)
  • In Brazil nostalgia grows for law and order (Washington Post)

Investor Watch:

  • James Donald of Lazard on Emerging Markets (bloomberg)
  • EM stocks are still relatively cheap (SCMP)
  • Blackrock’s quant strategy (FT)
  • Soros-Rogers interview (Twitter)
  • Li Ka Shing call it a day (SCMP)
  • Electric vehicles will be cheaper than regular cars in 7 years (Bloomberg)
  • Will China out-innovate the West (Project Syndicate)
  • Momentum Investing is Easy – So Why Does it Work (Behavioral Investment)