I’m Not Betting on Emerging Markets… Yet!

After topping out between 2008 and 2010, emerging markets have woefully underperformed the US. I remember at the top the extreme amount of optimism that investors had towards China and other developing economies, while the US was shunned.

Emerging Markets vs. S&P 500 Performance

I first expressed my bearishness on emerging markets in a blog post in early 2007 titled “Beware of Emerging Markets”. It turned out to be a correct stance. The $EEM ETF got cut in half in the next year during the financial crisis, and, although it recovered all its losses, is still trading at the same levels from the time of my blog post nine years earlier.

Emerging Markets Equity Returns

My bearishness stemmed from the massive credit-fueled mal-investments that were made during the early part of the last decade in emerging economies. This was caused by a series of events: first, China entered the WTO in 2001 with a cheap currency and a large, low-wage workforce that it utilized to manufacture goods cheaply for the world; second, Greenspan kept interest rates artificially low to counteract  the fallout from the bursting of the technology investment bubble; third, borrowed money poured into China setting off a fixed asset investment boom there; fourth, the industrialization of China drove a huge demand for energy and metals, creating a commodity bubble; and finally, most emerging economies, which are commodity producers, also boomed due to an inflow of capital into mining and related industries.

Emerging markets are now dealing with a commodity downturn, large US dollar-denominated debts, and weak global growth. Complicating problems is that the US is experiencing solid growth and the Fed is embarking on a rate hiking cycle. Whenever, the US appears to be a more attractive investment destination than emerging economies, capital will gravitate towards the US and cause a loss of reserves for emerging economies, thereby tightening financial conditions.

I find it hard to pinpoint when this pressure will abate for emerging markets. In my view, the US economy will remain in decent shape and interest rates will go higher in the next couple of years – all of which suggest that the US is still the better place to invest. That said, I am compelled by emerging markets’ equity valuations which are at the low end of their historical range.

Emerging Stock Market Forward PE Ratio

The price to book ratio conveys a similar message.

Emerging Markets Price to Book Valuation
Source: J.P. Morgan Asset Management Guide to the Markets, March 31, 2016

Earnings expectations have experienced a substantial decline and are reflecting a further deterioration in economic conditions.

EM Earnings Expectations
Source: (Left) J.P. Morgan Economic Research, J.P. Morgan Asset Management. External debt includes public and private debt. (Top right) MSCI, US Federal Reserve, J.P. Morgan Asset Management. (Bottom right) FactSet, MSCI, J.P. Morgan Asset Management. REER is real effective exchange rate.
Guide to the Markets – Europe. Data as of 31 March 2016.

Unlike nine years ago, when I wrote my initial bearish post on emerging markets, sentiment has reversed and investors are favoring the US over emerging markets. Coupled with cheap valuations, emerging markets may be a great long term buying opportunity. In fact, I have bought a tiny position in Brazilian and Indian stocks to motivate me to keep a close eye on those markets.

However, I am hesitant to commit a bigger position to emerging markets. My experience has taught me that bearish sentiment and cheap valuations can remain for a very long time. Often the trigger for starting a new bull market is the assertion of favorable economic and business conditions. Unfortunately, I do not see any evidence of that just yet.

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