Macro, Foreign Emerging

Emerging Market Equities: Separating the Wheat from the Chaff

November 30th, 2015 | Nick Sargen

Highlights

  • Since 2011 emerging market (EM) equities have lagged U.S. equites considerably, and the valuation for the MSCI Emerging Markets index has fallen to a record low recently. While this could signal a buying opportunity, our view is an underweighting of the asset class is warranted amid a significant slowing in credit growth and uncertainty about how EMs will fare when the Fed tightens policy.
  • Nonetheless, this is a good time to formulate a strategy for investing once conditions stabilize. Because there is likely to be considerable variation in the performance of individual markets in the future, careful country selection will be critical to success.
  • The challenges are formidable, because the nature of emerging market crises has evolved and countries confront a myriad of problems with differing policy choices. For example, the build-up in debt since the Global Financial Crisis has been greatest in China and other Asian economies, but they also have leeway to ease monetary policies because inflation is low. By comparison, countries such as Brazil, Russia, and Turkey have less latitude to ease policies with inflation high.
  • An ongoing challenge is to assess whether expectations that are priced into markets will be met, which is not easy. A noteworthy example: The BRICs concept became popular when China's emergence contributed to a commodity boom, but it has lost relevance today as expectations proved to be unrealistic.
 

EM Equity Underperformance: Secular Forces

Over the past year, investors have increasingly become concerned about the ongoing slowdown of China's economy and the spill-over it has had on other emerging economies. The combination of plummeting commodity prices and currencies and deteriorating corporate profits resulted in emerging market equities posting an overall decline of 9.4% through the end of October. At the end of September, when returns were minus 15%, equity valuations based on the MSCI index had fallen to a record low of 12.8 times 10-year average earnings, or roughly one half the long-term average. Read more.