Three reasons to reconsider emerging markets

The numbers don’t lie — emerging equity markets (EMs) have dramatically lagged US equities in 2018 as shown in the table below. The chaos in EM is best exemplified by the Brazilian elections, Russian sanctions, deleveraging in China, and the South African land redistribution policy. However, in some cases, factor-based approaches fared better than the overall market in EM, and I believe there are three indicators suggesting it may be time to reconsider this asset class.

Signs of EM life

Year to date, the MSCI Emerging Market Index has fallen 7.40%. That was surpassed by the Low Volatility factor (the S&P BMI Emerging Market Low Volatility Index rose 1.70%) as well as the fundamentally weighted FTSE RAFI Emerging Markets Index, which was down 2.59%. The Momentum factor turned in mixed results in EM — the S&P Momentum Emerging Plus Large Mid Cap Index was down 7.13%, slightly outpacing the MSCI Emerging Market Index, while the Dorsey Wright Emerging Markets Technical Leaders Index contracted 9.91%. In my opinion, factor-based strategies represent alternatives to a market cap methodology with the potential to add value to an EM portfolio.

Outside of factor strategies, the 20% rally in the technology heavy NASDAQ-100 Index and the 20% decline in the Alphashares China Technology Index is eye-catching in terms of highlighting the difference in EM and US equity market performance this year.

Select index returns highlight the underperformance of EM stocks versus US

Source Bloomberg, L.P. as of Sept. 30, 2018. Past performance is not a guarantee of future results. An investment cannot be made directly into an index.

Three reasons to look at EM

I see three reasons why emerging markets may find support in the coming months.

  1. The case for US stocks may look less compelling in 2019. US small caps have been firing on all cylinders until very recently, supported by the favorable impact of the 2017 tax cuts, the relative strength of the US economy, trade war uncertainties and economic chaos in EMs. Through the end of the third quarter, the S&P Small Cap 600 Index had rallied 14.54%. But going into 2019, US small cap earnings may have trouble keeping up with their performance this year, creating a headwind to their return profile. Moreover, the ongoing impact of Federal Reserve tightening and the fading effects of the tax cut may slow profit growth. I believe the small-cap sector is unlikely to outperform like in 2018, and that emerging markets may start to look better by comparison.
  1. Trade clouds may be breaking up. The trade picture may be beginning to clear. A new trade agreement between the US, Canada and Mexico has been struck, and the outcome of the US mid-term elections could shed more light on the willingness of China and the US to make a deal. China seems to be hoping President Donald Trump loses political momentum. If Republicans hold onto their strength in Congress after the mid-terms, that may push China toward a deal. But if Republicans suffer election losses, that may create more US willingness to deal with China. In any case, the November elections could be a pivot point, especially with the recent deal in North America. An improved trade outlook may benefit emerging market economies and foster more risk-taking.
  1. Emerging market dysfunction is well-known. The MSCI Emerging Markets Index has declined about 25% this year from the Jan. 29 high to the Oct. 11 low. The bearish picture is well-priced in these markets, but there are potential positives on the horizon. China is working to reflate its economy — although success is uncertain, the credit contraction is stabilizing and tax cuts are being implemented. The Brazilian election will eventually be out of the way (the second round occurs Oct. 28), and it may result in some policy clarification by year-end. In Russia, any investors who fear the potential impact of sanctions have likely left the Russian equity market already, and the firm tone of oil has bolstered the growth picture for the Russian economy.

Possible signs of a bottom?

Picking a bottom is a risky game, but the MSCI Emerging Markets Index recently found support at the 950 level. Likewise, the Chinese Shanghai Shenzhen CSI 300 Index is approaching psychological support at 3,000 after tumbling nearly 30% from its January 2018 high. The recent Bank America Merrill Lynch Fund Managers survey indicated that respondents had lost their appetite for emerging markets. Both current positioning and intentions for the next 12 months were said to have turned negative or neutral.[1] This may be a sign that the emerging markets are poised for a comeback.

Those interested in emerging market investing can explore Invesco’s emerging markets EM line up by clicking here:

1 Source: Bank of America Merrill Lynch, “BofA Merrill Lynch Fund Manager Survey,” Aug. 2018

Important information